August 13, 2007

As my managing priorities have drawn me away from writing it has been over a month since I have written an updated piece for the website.  I have had two recent requests for my insights on recent market behavior.  In both instances I had to warn that my matter-of-fact response should not be viewed as cavalier or uncaring about investment portfolio values.  The truth is, no matter how much it bothers me or you or anyone else, the market is defined by its volatility.  Without that risk there is no potential for reward.   And these all-too-typical dips happen all too often (and are accompanied with far too few good predictive tools) to consistently sidestep.

But in this article I want to do two things.  First I will (perhaps redundantly) review the statistical history of US market corrections and remind us all that nothing irregular is (yet) happening in the stock market.  Second, to show that I do not take market corrections lightly I will share what I am looking at and what my current strategy is (emphasis on “current”).

So, first, the statistical history.  I purposely entitled this piece “Revisiting May 3, 2007” because on that day I released the article “Correction Coming (but they’re always coming)”.  In that article I wrote (and I encourage you to go back and re-read that piece):

“…, more than three times every year we should expect the market to go down five percent; and at least one of those three pullbacks should shrink portfolios to the tune of ten percent. 

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?). “

So, as painful as it can be (it always is, because we forget about them), we already knew this correction was coming and embraced it as regular and ordinary.  So we already had that conversation, this is just an update.  To be clear, although our guess (emphasis on “guess”) was that the 10% correction would occur in the next few months (August-ish, the summer doldrums), that timing was as much luck as anything else.  The tools available for perfecting timing these types of bumps-in-the-road are very weak (which is why investors prudently ride over those bumps, and just try to swerve to avoid the larger potholes).

From its July 19th peak the S&P 500 had fallen almost 7.8% (at its current worst) in just 15 days.  Typically these types of corrections take 60-90 days.  There is not a lot of good historical context to argue whether this accelerated price descent is good news or bad news.  It is certainly possible to argue that the more typical and lengthy process of stock market corrosion we usually find at the end of bull markets has been accelerated due to the deflating of triple bubbles (real estate, credit, and private equity).  And I would probably accept that sort of “hunch-work” as more probable than something rosier, like that the quick correction was more like ripping off a band-aid – that it was better to just get it over with.  No, the rapidity of the price movement pains me more than it soothes me.

Aside from hunch-work, we can look at a few other things.  Valuations are good.  The global economy and profit growth are both still accelerating.   On its recent lowest point the S&P 500 dipped below its 200-day moving average but then jumped almost 4.5% in the next three days (none of which were 9-to-1 up-days, which I’ll explain later) – hugely offsetting the rapid decline and showing that the market wasn’t quite ready to break down technically (not yet anyhow).

O.K., I’m throwing a lot of indicator evidence at you and most people like to just know the bottom line.  I’ll close with that, but for now let me focus on the current second-most important indicator (the most important being the trend).  That important indicator is market breadth (the amount of up-volume vs. down-volume).  As history has shown, it doesn’t much matter if the volume is heavy up or heavy down, extremes in either direction are bullish.  In the industry common terminology for trading days in which the upside volume is nine or more times downside volume is called a 9-to-1 up-day. And the converse (when downside exceeds upside volume by the same ratio) is called a 9-to-1 down-day. 

A 9-to-1 up-day (especially back-to-back 9-to-1 up-days) is very bullish as they typically indicate that selling has become exhausted and now demand had picked up enthusiastically.  Also, strong demand over a longer period of time (60-90 days) is also bullish, even if extremes are not met.

And 9-to-1 down-days can be bullish because they can signal that selling is so bad, that it’s good.  These types of signals can show capitulation – that owners have thrown in the towel at whatever prices buyers will give.  The problem with this indicator is that you have to measure these 9-to-1 down-days in conjunction with a lot of other evidence because you can have a string of 9-to-1 down-days before the market is ready to turn (in other words, the end of mid-level corrections/crashes are hard to pinpoint with any real precision).

Now, I told you all of that so that I can take you through some recent history (Why?  So that you know what the guy who is watching your portfolio is watching – so I would say this is fairly important information and worth your read).

On both July 24th and July 26th the markets experienced 9-to-1 down-days (the market had peaked a week earlier on July 19th).  This immediately forced investors to try and figure out whether we the bull market was still intact or whether we had entered into a new bear phase.  Based on a pile of positive indicators the bulls had (so far wrongly) been given the benefit of the doubt.  The 26th was a clearer signal, and the S&P 500 is down about 2% since then, and down about 3.3% at its worst.

Then on August 3rd (two Fridays ago) the stock market tanked about 2.7% in just that one day, which set up the third 9-to-1 down day since the market peaked.  And I am afraid to say that, historically, three 9-to-1 down-days (without an intervening 9-to-1 up-day, which would be very bullish) is a very negative occurrence for the stock market.  It could further be argued that the 9-to-1 down-day on June 7th was part of a succession of 9-to-1 down-days, putting us at four such days.

To put the three (or four) 9-to-1 down days into perspective, it is important to note that many of these may occur during a bear market (but usually spread out about a month apart from one another).  For example, there were seven such days in 1962, six in 1970, fourteen during 1973-1974, and seven in 1990.

In most historical cases in which there have been three or more 9-to-1 down-days the winning strategy has been to be invested when the last downside day was achieved.  Of course the timing of which is only known in retrospect, so the ideal plan is to be invested shortly after an upside reversal on strong breadth (i.e. a 9-to-1 up-day). 

Now, to the question, “why don’t we just sell everything and hold all cash”?  Well, the first answer is that, as reminded above, the markets do this volatile dance very regularly – they markets go up the markets go down.  And whether we like it or not it is the nature of the market.  It is that very action that allows us to be rewarded for investing.  Second, because earnings and valuations are all good.  There are pricing problems (and credit concerns), but there are not problems with growth or earnings (i.e. currently we need to worry about price momentum; we are not worrying about global economic deterioration).

The Bottom Line:  Any cash positions I would look to invest following a 9-to-1 up-day.  If there are rallies on weak volume I would look to eliminate weaker positions and temporarily hold cash.

The Risks:  By waiting for a clearer signal before leveraging equity stakes and/or by eliminating equity positions on weak rallies an investment portfolio could very well ( and very markedly) underperform stock market indices.  Unless I am specifically directed otherwise by a client, I am leaning toward the risk/mistake of taking a conservative tact (as opposed to being more aggressive now only to see the stock market resume its sinking).