January 30, 2008

My apologies ahead of time.  This is a bit of a technical update.  Not that there has been a shortage of fundamentals to report on this week (the GDP report, the FOMC meeting, employment reports and jobless claims, downgrades of bond insurers, etc.), but my guess is that there has been enough coverage of these topics for everybody in the conventional media.  I know that my very own local Podunk local newspaper has covered most of these, so yours probably has, too.  And if you clicked any of the “Useful Links” on www.BerkshireMM.com, then you definitely had more than your share of coverage.  So while I am considering all of these factors, I wanted to use this article as an opportunity to share with you other factors that I consider which you may not be able to so readily read about.

A week ago there were some very convincing buy/hold signals for the stock market.  Those signals are listed in the January 23rd, 2008 article “When everyone is looking one way…”.  From peak to trough we have seen the Dow climb 1,207 points.  But, as impressive as that rally has been in point terms, the internals have been disappointing.  The breadth of the advance (advancers vs. decliners, volume, etc.) suggests that there has not been a resurgence of demand, the type of demand that is needed to see sustained buying leading to a new cyclical bullish rally.

Instead we have seen the “junk” of the market (the sectors that have been beat up the most during the decline) bounce in “V”-shape off of their lows.  Banks, Home Builders, and Consumer Discretionary stocks have jumped the most, leaving other sectors and subsectors well behind.  Also, unfortunately for the bulls, the volume has actually been declining steadily over the last week.

To be clear, what we would have liked to see over the last week is 1) broad demand (i.e. buying of all sectors, not just bottom-fishing of the biggest losers), and 2) spiking volume due to a resurgence of fresh demand (as opposed to primarily an exhaustion of selling). 

This is important because, as we wrote in our Outlook for 2008, we felt that the leading sectors and asset classes would change leadership during the year.  For example, in the first part of the year we see Health Care Consumer Staples being market leaders then in the second part of the year we see Information Technology and Consumer Discretionary doing better.  But with the convincing buy/hold signals of last week, I had to ruminate long and hard as to whether or not that the sell-off was a demarcation between the first part and the second part of the year.  Was the first part of the year only three weeks instead of the anticipated four or five months?

But instead of identifying last week as a clear and early demarcation, I am expecting a retest back to the 1275-1300 level on the S&P 500. 

But with that bad news, there is good news.  To get to the good news, you have to think about what happened on January 23rd; stocks had fallen more than 10% from their peak, they experienced a 5% intraday swing, and then closed up 2%.  Since 1946 that has only happened nine other times.  As the chart below indicates, the median returns 1-, 6-, 9-, and 12-months after such a day as January 23rd saw median gains of 3.0%, 5.5%, 15.7%, and 19.6%, respectively, greatly surpassing the returns of all periods measured over the same time frame.

                                    Dow Jones Industrials Gain, Trading Days Later

With supportive data such as this you might wonder why I would even comment on a potential retest, especially since it would likely purge any remaining sellers and probably occur just as fiscal and monetary policy were ready to take hold.  I bring it up for two reasons, one of which is to mentally prepare you and to invite you to call us if you are concerned about short-term downward volatility. 

The other reason is that which I mentioned before; as a money manager I need to find that demarcation between the first part of the year (bearish, caused largely by recessionary concerns) and the second part of the year (bullish, based on expected economic improvement).  As a money manager, I can’t just have an opinion, I must make a decision.  So, for right now, I am still bearish over the first part of the year and expecting a retest to the recent market lows.  As such, I am not yet ready to abandon defensive positions like Health Care and Consumer Staples in favor of more aggressive positions (although, due to growing political headwinds, I do hold the right to modify, at any time, my position on Health Care).

In the Outlook for 2008 I wrote extensively about this concept, but I want to close by adding to it. 

There have been three recent periods that are pretty similar to now.  Those periods were September 1989 through September 1990, April 1998 through August 1998, and September 2000 through September 2002. 

Similar characteristics between those periods and now include: stock market performance 3-, 6-, 9-, and 12-months prior to a decline, stock market returns during the decline, a Fed easing cycle, the risk of recession, weakening global financial markets, volatility increasing from low levels, slowing earnings growth, and credit spreads widening from low levels.

Granted, history never does repeat itself, but it often times does rhyme.  In those past three periods, periods very similar to today, a preponderance of market beating stocks were in the Health Care and Consumer Staples sectors.