September 3, 2008
- The day after the mid-July 2008 low (the S&P 500 hit 1,200 points), Berkshire Money Management projected that the S&P 500 would move toward 1,325 points, and it has. However, at the same time, we also noted that we intended to sit out that expected rally as we assessed its sustainability.
- The patterns of the upswing from the mid-July market low have been typical of those found in brief bear market rallies, not of new bull markets.
- Is this time different? Exceptions are always possible, but they are not probable. And investing is a business based on probabilities.
On July 15th the stock market plunged to new lows for the year. The very next day was a fairly bullish day for the stock market (in terms of price direction and magnitude, volume, breadth, etc.). So I wrote an article that night arguing that the S&P 500 could very well bounce up to 1,325 points over the next few months.
However, that day – as noted – was merely “fairly” bullish and not “very” bullish. So, regarding that expected stock market bounce, I wrote that “we are willing to miss that rally as we assess the probabilities as to the sustainability of any renewed bull market”. Admittedly, that sounds a little wimpy. However, it is the very nature of bear markets to entice investors to jump back in too soon. If history has taught us any lesson, it is to remain skeptical of every rally attempt until the evidence is compelling that supply has dried up (i.e. everybody who wants to sell, has sold) and that there is new and rejuvenated demand from investors looking to get back in.
A month-and-a-half after that self-described wimpy “the market is going to go up, but I’m just gonna sit on the on the sidelines and watch” explanation, we have seen the S&P 500 close about 1,300 points twice, and also trade to an intraday high of 1,314 points. As such, I felt it was appropriate to share my inspection of the rally at this time. After all, just because the market has gone up in the last few weeks, well, let’s just say that past performance is no guarantee of future results.
That old legal cliché is especially true in bear markets. Over the last 80 years, any bear market that has produced at least one 2-monthy rally (like March to May 2008), usually contained a number of similar rallies commonly lasting from one to three months, followed by new bear market lows. Given that this current rally is still within that span of time, this could very well be a bull rally within a bear market (sometimes known as a “Sucker’s Rally”).
To fully explore this rally, we will go right to to the beginning. Or more precisely, we will go to even before the beginning. When the mid-July 2008 market low was being formed, it lacked signs that “the” bottom was being made, which made us skeptical from the beginning.
To put this current rally into perspective, let’s compare it to the March-May rally. We have often stated that, ultimately, the price of a stock (like the price of anything) is based on supply and demand. Prior to the mid-March low there were three days of climax-like selling – 90% downside days. (where downside volume equaled 90% of total volume). And one of those days occurred just before the low, thus increasing the odds that sellers had exhausted themselves (in other words, supply had dried up). Furthermore, a 90% upside day (where upside volume equaled 90% of total volume) occurred just one day after the market low, suggesting that prices had been driven low enough to attract broad and enthusiastic buying.
In contrast, prior to the current rally there were two 90% downside days, neither of which occurred during the last two weeks of the mid-July low (it happened on June 26th). This suggests that the last three weeks of selling was mild and that sellers had not yet been exhausted (thus leaving potential for more selling).
Since then, we’ve seen some big single-day moves. We prefer to use the S&P 500 as a more relevant metric, but the Dow Jones Industrial Average (DJIA) gets the most attention. And on both August 5th as well as on August 8th the DJIA rallied over 300-points. Just as we should not get overly enthusiastic about a rally lasting a month or two, nor should we lend much credence to big days if, in fact, those big days are not made up of the right stuff.
For example, the two aforementioned days were the 7th and the 8th times the DJIA gained 300-plus points since the broad market peaked in July 2007. In each previous case the market followed with new lows. Is this time different? Asked another way, were these – the 7th and 8th big up days – made up of the “right stuff.” Seemingly not.
In terms of important factors such as the number of advancing issues, accumulative points gained, and up-volume on the NYSE, these two 1-day rallies were the weakest of the eight cases. While it is still possible that we will see rejuvenated demand with better big up days, it is worthwhile to note that if the six stronger cases did not result in sustained uptrends, it is unlikely that the weakest cases will prove to be the exception.
To give this volatility further context as to whether or not we continue to be in a bear market, note that there were 16 days on which the DJIA gained 300-plus points during the 2000-2003 bear market. Interestingly, from March 2003 through July 2007 there was not one single case in which the DJIA went up 300 points in a day. It appears as if volatility is more common in bear markets, and rarer in bull markets. While volatility in general is common in the stock market, the more extreme the volatility the more likely we remain trapped in a bear market that will likely, at least, test the July lows.
Admittedly, observation of 300-point up days is a little arcane. More fundamentally, but still suggesting the same, this rally has seen little evidence of buying enthusiasm. Historically, if the preceding panic liquidation had driven stock prices down to dramatic discounts, investors should have recognized the bargains and rushed back into the market, creating a 90% upside day (preferably more). But there were no 90% upside days anywhere near the mid-July low, making it unlike the start of any major bull market we’ve seen since the 1930s.
Breadth and upside volume typically explode upward during the early months of a new bull market as investors perceive the new, lower prices to be bargains. This is a highly consistent pattern of aggressive accumulation that has been lacking over the last six weeks. Instead, we have witness highly selective buying (mainly in financial stocks) on diminishing volume.
Bottom line: If in “normal” times an investor should be 100% invested in equities (with the majority of that exposure in US equities), then in this environment an investor should be underweight equities with an allocation closer to 75%.