Insights & Advice


Revisiting the Risk Level

Febryary 11, 2008

  • January was a horrible year for the stock market.  Even the “hedged” management of hedge funds was down considerably for the month.
  • Our January 23rd call for a rally and our January 30th call for a retest both were incredibly accurate. 
  • Our Outlook 2008 Risk Level of 1,300 points on the S&P 500 in the first four to five months of the year has so far held on a closing basis.  We continue to believe that getting back down to (and holding) the 1,270–1,300 level will be a positive for the stock market in the second period of the year.
  • The 1,270-1,300 level will likely hold, but we have contemplated actions should it not do so.
  • Insider buying was exceptionally bullish in January, suggesting that 1) the stock market will be higher 12-months out, and that 2) a stock market bottom is near.
  • We list several reasons to believe that any low for the stock market’s decline will be anywhere from January-May, as defined in our Outlook 2008.

In the Outlook 2008 report that we issued on January 1st we defined the calendar year Risk Level of the S&P 500 to be 1,300 points.  Additionally, we cited that should we get to this level that it would occur within the first four or five months of 2008.  On January 22nd the S&P closed at 1,310 points (it hit an intra-day low of 1,270 the next day).

Admittedly we (and that is a collective “we” not just for Berkshire Money Management but for pretty much everybody in the world – literally) were caught off guard at how incredibly quickly and in such a linear fashion the decline occurred – a mere fourteen trading days.  Even the best paid managers on the Street were taken by surprise.  The average stock-oriented hedge-fund was down 4.1% in January – and don’t forget, hedge-funds are, well, “hedged” by short selling stocks (i.e. betting against a declining market).  And still they were down the most for one month since they were collectively down 4.3% in November 2000 as the January decline occurred so rapidly and so unexpectedly that they were not able to either take advantage of it nor get out if its way.

But now that we have at least crossed the 1,300 mark we should take the time to re-examine that risk level.  On January 30th I wrote the “Retest Coming” article explaining why I thought that after a 6.7% rally that the S&P 500 would retest those 1270-1,300 levels.  I got pretty lucky on the timing of the article since last week that same index dropped 4.6%.  When I wrote that January 30th article I am pretty sure that the premise would have been dismissed by most.  But 4.6% later it doesn’t seem too far fetched to even the most optimistic Pollyannas to think that we could now get back to the 1270-1300 level. 

But the question is, will it hold?  (Without getting into it right now, if it doesn’t hold I’ll probably be selling some equity positions).  I originally used the 1,300 mark as the 2008 Risk Level because it represented a trailing 12-month P/E of 16.4 for the S&P 500 (its 36-year mean).  Curiously, if you update trailing earnings using updated Q4 2008 numbers then that value gets reduced to 1,366 S&P points (pretty close to the 1,270 intra-day level of January 23rd).

Now I am the first one to admit when I need to change a forecast (remember Keynes:  “When the data changes I change my mind.  What do you do, sir?”)  After all, the average stock decline for stocks during a recession (more on this later), peak to trough, is about 25%.  That would bring the S&P down to about 1,181 points (or about 12% from current levels).  But for now, for 2008, the more probable downside risk is another 5% (to 1,270 – 1,300), give or take 1% or 2%.

That the S&P might make a slightly higher or lower low is not as important as the volume and breadth that occurs during a retest, similar to how I described my concerns regarding the recent rally.  The low-volume, weak-breadthed V-shaped rally was not indicative of a sustainable advance; bulls will want to see us hit 1,270-1,300 points and remain at near those levels for a while (building a base, as they say).  The repair processes of an ailing market are commensurate with the declines they are attempting to reverse.  It would be nice to see a whole lot of nothing for the next couple months.  Or, if buying were to resume, we would want it to be on heavy and be broad based volume (as opposed to what we saw in the late-January rally).  But with the much of the economic data of the last couple months being dour and with the coming months probably bringing similar mixed information, I am hesitant to believe that any sustainable buying interest will resume so quickly that it will be of the quick, V-shaped variety.

The P/E gauge is one piece of guidance, but there is more updated evidence.  Not evidence that 1,270-1,300 points will necessarily hold, but that 12-months out the market will likely be higher than whatever the ultimate low happens to be.  Specifically, corporate insider buying seems to have signaled that we are near market bottom. 

Corporate insiders are defined as chief executive and operating officers, directors, senior officials, and other major shareholders.  Because most high level executives are paid in the form of receiving shares of sock, the amount of selling by corporate insiders never really proves to be a clear signal because it occurs based on many non-company factors that affect the individuals (ex. financial planning due to excessive allocation, buying a yacht, charitable contributions, and to just plain supplement income).  As a result, the ratio of selling-to-buying for corporate insiders is usually neutral between 2.0 and 2.5.  Anything below 2.0 (2 sellers for every buyer) is generally positive for the stock market.  It is rare for the amount of buying to exceed the amount of selling.

Historically, insider buying is bullish because they are in the best possible position to assess the outlook of their companies in relation to the economic outlook.  In other words, to quote a line that I read, “if it is so bad, how come these guys are gobbling up their own companies’ stock?”

The January 2008 insider data, as provide by the Washington Service, confirms that a bottom is at hand and that the 1,300 Risk Level is about right.  As mentioned above, it is rare for the amount of buying to exceed the amount of selling.  But last month the amount of purchases were 1.44 times more than the amount of sales.  This was the first time since January 1995 when the purchase of stock during a month outpaced sales.  That year the market rallied 34.1%.  There were also periods of net buying buy insiders in March 1994 and September 1990, both of which were followed by rises in the market during the following year. 

To be more detailed, the second week of January was the big week for insider purchases.  It was the strongest week’s worth of data since August 2002, just two months prior to the end of the bear market. 

The numbers can be volatile, so to be conservative we should also inspect an eight-week moving average.  For the last eight-weeks the sell-to-buy ratio was 1.39-to-1 (1.39 sellers for every one buyer), well below the bullish ratio of 2.0-to-1.  The last time the ratio was this low was in November 20002, just one month after the end of the bear market.

To be sure, insiders are not perfect.  As indicated above, in one instance insiders were two months early, and in the other they were one month late.  And certainly insiders’ got burnt in the third week of January after their aggressive purchases in the second week.  Since large losses can occur after even the most bullish ratios of insider purchases, there is no short-term market timing significance.  Insiders often tend to be early in their purchasing decisions as they try to get ahead of the good news they seen on the horizon.  The interpretation of this data is that a year out the stock market will be higher than the its ultimate 2008 low. 

If we do happen to be in a recession then it probably started in December, maybe January.  And in that case it is important to note that the stock market, on average, tends to begin trending up five-months into the recession, so in April or May.  As you recall, in the Outlook 2008 we demarked the first period of the year (the first four or five months, so up until April or May) would be weak for the stock market (with a Risk Level of 1,300 points). With that time frame in mind it is also important to note that, in times of economic crisis the federal government is notoriously late in trying to help.  In the past, by the time government help arrives the problems have already taken care of themselves.  The 2008 stimulus plan actually was put together in record time, and checks will likely start to be mailed out in May and June (granted, not a very scientific gauge of a possible near-term bottom, but I thought it was worth mentioning given the government’s track record).

Even if we are fortunate enough to hold the 1,270-1,300 levels on the S&P 500 we should not expect to begin seeing an impressive firming of stock prices for another few months.

Let’s say that a recession did start in December, the average recession lasts about 10 months, or until September.  In bear markets that were associated with both a recession and Fed easing cycles, the last rate cut has occurred after the recession ended in five case and coincident once (a median of 0.5 months after the recession).  So, historically speaking, the last Fed cut could be the September 9th meeting (a 25 basis point cut at each meeting would then put the federal funds rate at 1.75%).  Also in these same type of periods, the stock market has bottomed before the Fed finished its easing cycle, doing so by a median of seven months.  That would put a bottom in the market around, well, this February.

You could stretch that out and note that during a recession the average market bottom occurred about five or six months after the recession started, so April or May.  That time-frame is entirely possible, but it is also important to note that on average, for the last ten post-war recessions, the six-month decline of the S&P 500 after a recession started has been 4.83%.  We have already sustained considerably more damage than the average, suggesting that a bottom has been identified.

A successfully held retest of the 1,270-1,300 mark on the S&P 500 this month is very much in line with the Outlook 2008 report, valuations, insider buying, and historical occurrences.  If we can get that, then we can then turn our focus to the longer-than-anticipated second period of 2008 (10 months instead of 7-8 months).