Tuesday, September 2, 2013

September Slide

 The stock market has seen losses of roughly five percent, or about half of the total expected decline over the next three to six weeks.   Before this current correction is over, selling is likely to increase.

• Berkshire Money Management uses a combination of technical and fundamental tools to identify true bull market tops that lead to bear markets.  Thus far there are no signs that the recent market activity is anything other than that of the ordinary five-to-ten percent variety.

Historically, September is the worst month of the calendar year for the stock market. And, with August’s losses in the books, investors are taking one month’s worth of activity and extrapolating it into a forecast of a new bear market to come. However, since forecasting is often not far removed from guesswork, investors are traditionally better served by allowing the market itself to indicate when and where a bottom has formed and a new, sustained rally has emerged.

As of the time of writing this note, the stock market has seen losses of roughly five percent, or about half of the total expected decline over the next three to six weeks.  The previous ten-percent correction for the stock market saw its end in November 2012. As that was some ten months ago, a correction of that magnitude is not only close to being about due (as they occur, on average, about once every fourteen months), it is ordinary and regular.  We are aware that for those with distaste for volatility that this fact can be perceived to be a cavalier attitude regarding stock price fluctuations (even though there is little, if any, concern regarding volatility of prices to the upside).

Quite frankly, price volatility is the cost of doing business when invested in equities.  And thus if one has an investment horizon greater than a few months, one will quite simply have to learn to become weathered to the unfortunate fact  corrections in the range of five-to-ten percent are ordinary and occur too frequently to “time” so as to sidestep them.

The price drops in the ten percent range are sharp, and short (typically lasting only a couple of months), and tend occur with little technical warning.  However, true bear markets (the type Berkshire Money Management does attempt to sidestep) tend to occur as more of a process than an event.  True bull market tops, the type that lead to declines closer to twenty percent and persist for closer to a year) tend to show more gradual erosion, as investors find fewer and fewer stocks at values worth buying.  As a result, bull markets rarely collapse, but tend to wear out over an extended period of time, even as the markets hit new highs.

As such, the good news is that there are no signs that the recent market activity is anything other than that of the five-to-ten percent variety.  Because of that, there is currently no need to allocate large amounts of equity to cash or other conservative investments.  That type of tactical reallocation tends to be reserved for periods of greater concern.

The bad news is that, thus far, the decline in prices has more to do with a lack of Demand (it has been a buyers’ strike) than an increase in Supply (selling of stocks has not been exhausted).  Commonly, evidence that a correction has reached its final point is when the market has declined far enough to exhaust selling and drive prices low enough to cause investors to jump back into the market with strong, enthusiastic buying as they aggressively scoop up stocks at bargain prices.  That evidence has yet to present itself, so we await some climactic panic selling that will likely bring the market down a few percentage points more.

Stock market bottoms, whether ordinary corrections or larger crashes, almost always end with cascading prices that are robust in terms of both magnitude and volume.  So before this current correction is over, selling is likely to increase.  However, selling alone is not enough of a signal to know that the worst is behind us; demand need also be robust, driving prices up in terms of both magnitude and volume.

Mathematically, this is but one reason why Berkshire Money Management does not attempt to time every stock market decline, even the ten-percenters.  An expensive or overbought market can continue to get more expensive or overbought, and often does so for many, many percentage points. Thus getting too conservative too soon can mean leaving considerable gains on the proverbial table.  And since the market can easily move one percent in a day or two-to-three percent in a week, we really need to see a three to six percent pullback to gain evidence that a ten-percent correction is underway.

At the point where there is evidence enough to expect a ten-percent decline, we’re already halfway done.  But then, after the market drops a few more percentage points to provide that aforementioned intense selling, the market needs to exhibit robust buying, often in the form of two-to-four percent in just a mere couple of days.  So by the time a correction is clearly underway and noticed, the selling and subsequent rally to offer suitable evidence that the correction is over brings the price level pretty much right back to where it was when it was identified.  (And then it’s quite often off to the proverbial races for the market – so you don’t want to be too late to get back into equities.)  Close-to-precision accuracy in sidestepping the correction offers little reward potential; missing a market’s bottom poses substantial opportunity loss.  There is just no good reason to try and defy the statistical probability of mistiming these regular and ordinary five-to-ten percent squiggles.

So what BMM does, and does well, is take precaution not when there is a risk of correction, but rather when there is a risk of a crash and/or bear market.  Currently, we do not see the risk of either a crash or a bear market.

Bottom Line:  With the market now close to an oversold level, investors should be alert for the signs of exhausted selling and rejuvenated buying signaling that the correction has ended and a new rally has begun.  This is expected to occur within the next three-to-six weeks (though current international conflict has the possibility of moving that timetable forward).