March 6, 2009
- In our February 9, 2009 article “Bottoming Process – a 15-Month Old Cliché” we wrote that “a ‘Bottoming Process’ is different than a bull market. A ‘Bottoming Process’ means that, net-net, investors have stopped selling.” We further explained that in order to determine whether now is “The” bottom (i.e. the beginning of a new multi-year bull market) or whether now is simply “A” bottom (i.e. a pause before the market drops further) that no good predictive tools existed. Instead we need to simply watch whether buyers or sellers enter the stock market and then to react accordingly.
- 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.
- There is a developing tug-of-war between the bearish fundamentals and at least some bullish technicals.
Bullish Technicals
The breakdowns in the Dow Jones Industrial Average (DJIA) and S&P 500 have been making a lot of headlines. But market breadth provides a less dire picture of the market’s action:
- Declining/Advancing Volume. The S&P 500 dropped to its new closing low, the ratio of declining volume to advancing volume was about three-to-one. That is far below the extreme ratios reached in October and November. That is a positive as it shows that any selling has been selective, as opposed to the indiscriminate and panicked liquidation of October and November.
- New Lows. New lows are expanding from recent levels, yet October and November included days with twice as many new lows.
- Global Breadth. Of more than several dozen benchmark indices that we use for global comparisons, only about half have dropped back to their November 20, 2008 levels. Among country indices, since then, emerging market benchmarks have outperformed developed market benchmarks (emerging markets account for 10 of the top 11, led by Brazil). This is consistent with performance tendencies after market bottoms as it provides a picture of markets looking ahead to the reflationary impact of the global monetary and fiscal stimulus.
- The NASDAQ Composite. The NASDAQ is a high-beta index that tends to outperform over the six months following market bottoms. Consistent with NASDAQ strength after bottoms, Technology has tended to perform best among S&P sectors after market bottoms. Since the November low Technology has been the second strongest of the 10 sectors, up about 7%.
As discussed in earlier articles, we are going through a bottoming process – a sort of range-bound flat-lined situation that needs to resolve itself by introducing to us the beginning of a new bull market or another down leg in the stock market. The bearish confirmation may still be ahead of us. But until we see it, the latest weakness can be viewed as part of the base-building process needed for a market recovery.
Bearish Fundamentals
A very big problem for novice forecasters (and even some more experienced ones) is that they take the very recent history and extrapolate it as a long-term prediction. For instance, I’ve spoken to people that lived through 1974, 1980, 1982, 1991, and 2001 and have all but forgot those recession (much less that they ended). And today they take the very recent history and say things like “this time it’s different, it will be years before the stock market and the economy turn around”.
These same types of people (pretty much all people, as we are all subject to the human condition) felt that in 1999 that the world would be forever prosperous. More recently, in the second and third quarter of 2007, when Gross Domestic Product (GDP) was over 4.7% in both quarters and the DJIA hit 14,000 points (and just before both started turning down) these same folks felt that the recent trend would never stop.
These are not dumb or uneducated people. They are just human and as such are subject to all the nuisance flaws that haunt us all.
I do often hear that “this time it’s different.” But they said that in 1974 with the oil problem; they said that in 1980 & 1982 when the US had a “double-dip” recession; they said that in 1991 when we went through our first-ever consumer-led recession; and they said that in 2001 as the US suffered the popping of a Technology bubble while simultaneously healing from the terrorist attacks. It’s always different – the only thing that stays the same is that recessions (even depressions) end and stock prices surge higher.
That being said, the current economic (fundamental) news is horrific. And two points need to be made on that subject. The first point being that we do not necessarily have to (nor should we) wait until the headlines of depression and despair are replaced with rosier mentions of job creation or even celebrity follies. A passage from Warren Buffet’s October 17, 2008 NY Times editorial “Buy American. I Am.” comes to mind:
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
The second point that needs to be made is a little less optimistic. While it is foolish to use recent history to attempt to forecast the future (even the near-term future), there is very little clarity as to the timing of the potential turn of the economy. And what clarity there is happens to be negative.
According to Friday’s release, GDP fell at an annualized rate of 6.2% in the fourth quarter of 2008 from the previous quarter. This is the biggest contraction in GDP since the first quarter of 1982. The enormous contraction is a further sign of how serious the problems in the U.S. economy are. (Over the past year, GDP has fallen 0.8%. This was the biggest year-over-year drop since a 1% decline in the first quarter of 1991.)
The GDP report is a clear indication of the current woes of the U.S. economy. As explained above, we must be careful to infer that what has just happened in the last few months will be what happens in the next few quarters. However, the report does indicate a contraction throughout most of the economy. The only exceptions are the federal government and inventories. And the increase in inventories is a problem as they will have to be worked down, thus subtracting from GDP.
Consumer spending is plunging, with the largest quarterly decline since the late 1970s. The housing market contraction has not slowed. And a big problem is that the contraction in business investment has been accelerating.
The economy should (emphasis on “should”) start to expand again toward the end of 2009 as the fiscal stimulus package gains traction and the efforts to restore credit take hold. However, risks remain firmly to the downside. If the stimulus is not large enough, or if efforts to rescue the banking system fail, the recession could last into 2010.
For equity investors, that difference of timing determines whether it will be a better time to buy stocks in June 2009 or March 2010 or some other time. And the significance of that difference is that it can lead to either buying stocks only to watch them drop precipitously or, alternatively, to watch stocks rise rapidly only to jump in after a lot of portfolio gains have been left on the table. (We got lucky buying stocks at the precise bottom in 2002, but we are not feeling so brave as to attempt to try that again.) As risk managers, we opt toward the second alternative – leaving money on the table.
If the bull market resumes…
Above, (for editing’s sake) we left out a few creative and professional strategies that we developed for different clients with different growth preferences. We look forward to sharing those strategies with clients individually.
If the bear market is confirmed…
We are holding a lot of cash. That is in great contrast to what other professional managers are doing; a recent survey by Financial Advisors magazine reveals that nearly two-thirds of manager’s clients are still 75-100% invested in equities. So, yeah, we are holding a lot of cash – enough where we are almost hoping that the stock market will keep going down so that we can buy stocks at even cheaper prices.
But should the bear market resume, that does not necessarily materially change the strategies we have created – but it will delay the implementation of such strategies as we continue to hold that cash.
Bottom Line:
There is a tug-of-war between bad-news and better-news-to-come as well as a bad-chart and getting-better-technicals.
We’ve got a lot of cash to get to work but we cannot yet muster enough confidence to jump back into the stock market just yet. We jumped into the stock market at the precise bottom in 2002, but a lack of economic clarity prevents us from assigning a high-probability that the lows are in.
Still, the economy will recover – and the stock market will begin its new multi-year bull market run before the economy bottoms. But even for growth-oriented investors we intend to be risk averse by getting back into the stock market only after it proves itself to us in the form of bullish momentum. By the very definition of that strategy that means we intend to miss out on much of the initial gains that would otherwise be captured from the bottom of the stock market’s decline. That is not good for performance management, but the emphasis here is risk management.