Research & Advice

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Short- and Long-Term Considerations

August 17, 2009

  • The US recession is ending and the economic recovery is beginning.
  • Short-term and Long-term stock market indicators differ, suggesting short-term risk and longer-term potential reward.
  • Any pullback should be monitored for an increased volume and an aggressive expansion in Selling Pressure, suggesting a deeper and more prolonged correction.
  • A pullback on moderate volume and a nominal rise in Supply (i.e. a larger withdrawal of buyers than increase of sellers) will probably best serve as an opportunity for new buying.

On July 1, 2009, in our “Second Half Update for Economic Outlook for 2009” we argued that the official end of the recession was in sight, and that the economy would begin to recover by late summer. Since many investors feared a depression late last winter and early spring, we have felt that the economy should be a main focus.

But now that the economy is showing clear signs of recovery, we would like to – for the moment – change the focus to short-term and long-term considerations of the stock market. In particular, we would like to explain – in part – why we believe what we do.

On June 15, 2009, in our “It Feels Like 1975” article, we argued that 1) the stock market would correct by four-to-six percent (the correction that started that day lasted three weeks and took the stock market down seven percent), and 2) the anticipated correction would not “at all diminish the possibility of something larger later in the year.”

More specifically, we have noted several times now that there is a good probability (specific percentages are arbitrary, but let’s say a better than 50% chance) of a two-and-a-half-month correction (perhaps lasting through mid-November) and dropping the market ten-to-fifteen percent.

Don’t take dates, duration, or percentages too literally – the point is that in the short-term we expect some stock market weakness. It is absolutely impossible to time the market both reliably and consistently. From time to time we get lucky and get things correct to the day (like our June 15th call), but other times we are not only late or early, but (and fortunately this is infrequent) just plain wrong.

So why bother writing about a correction that we expect? First, we want to let you know that it may be coming so that you are not surprised and frightened out of the market. Second we want to let you know what our long-term strategy of gaining “reward” is in relation to management of short-term “risk”. Lastly, this allows us to extend some level of education. We manage a lot of client money here at Berkshire Money Management, and we want you to have the opportunity to understand some of the research we use when creating your investment strategy.

Admittedly, some of that research is quite geeky and jargonish, but we’ll try to make it as “plain English” as is possible for this conversation.

Do you remember the Ron Howard film “Cocoon”? The plotline was that a group of elderly people were rejuvenated by aliens. (As I write that, it sounds sort of corny. But the aliens were merely a cinematic device to deliver a more profound – and more important – sub-plot.)

In the movie was a dialogue between a sheriff and his deputy, where the deputy was trying to explain how the older folks were gradually appearing younger. The deputy shared how when he was a teenager that he tried to buy beer using his older brother’s military identification, but he was kicked out of the liquor store before the clerk even looked at the ID. A couple years later the deputy tried the same trick again, and again the plan failed – but he got closer because at least this time the clerk looked at the ID. When the deputy finally turned 21 he could buy beer legally, but he was always carded. As the years passed by, he was carded less frequently. And eventually came a time when he was never asked for identification for proof of age.

The point the deputy was trying to make is that he couldn’t point to specific changes in the physical appearance of the elderly folks in question, but there were definitely subtle changes that were being made that – as time passed – became more and more noticeable.

To the market, there is some similarity. Major tops (and to a lesser extent, minor tops as well) in the stock market rarely occur suddenly. Rather, they are a process of gradual deterioration in strength. And with September – historically the worst month of the year for equities – nearly upon us, there are growing signs of deterioration. However, these signs are largely short-term in nature, while longer term indicators suggest that a strong market rally remains in place. A discussion of both sets of indicators (short-term and long-term) is warranted.

Possibly the most visible evidence of the extended nature of the market’s five-month rally is the heavily overbought readings on most short-term momentum indicators. However, while visible and often discussed in the media, overbought readings are less than perfect indicators of market tops as they can persist in strong rallies (think about the stock market in 1999).

Typically, signs of selective buying interest are more timely in signaling market tops. Such signs are, unfortunately, evident in the non-confirmations of recent rally highs in the major price indices by percentage of stocks trading above their 10- and 30-day moving averages. Expressed in a less jargonish manner, the divergences in these indicators suggest new rally highs are based on strength in a diminishing number of stocks. Thus, on a short-term basis, there appears to be growing evidence that an extended rally is becoming more selective and showing signs of forming a near term top.

On a longer-term basis, though, the evidence continues to appear positive. Longer-term measures of the trends in Supply and Demand (we tend to capitalize those two words only to emphasize how important both are in the determination of prices), are showing signs of increasing market strength. Since the start of the current trading range on August 3rd, Buying Power (i.e. the strength of Demand) has gained considerably while Selling Pressure (i.e. the strength of Selling) has lessened at a nearly as impressive rate.

This suggests a demarcation from the action of Buying Power & Selling Pressure over the prior few months, when rallies were based more on contracting Supply (i.e. less selling) than expanding Demand (i.e. more buying). Demand is important because over the last century sustainable bull markets have been coincident with Buyers aggressively purchasing stocks as they accumulate them as long-term investments, as opposed to shorter-term (and lower volume) trading. To understand the reason why investors may be starting to accumulate stocks for the long-term (i.e more buying), simply jump right back up to the beginning of this missive – the recession has ended and the recovery is beginning.

Bottom Line: Current signs of weakness appear largely short-term in nature, while longer term the rally appears to be showing signs of renewed strength. That said, any pullback should be monitored for an increased volume and an aggressive expansion in Selling Pressure, suggesting a deeper and more prolonged correction. A pullback on moderate volume and a nominal rise in Supply will probably best serve as an opportunity for new buying.