Tuesday, June 01, 2010
- The stock market appears poised for a summer rally. Whether that rally lasts the entire summer is another question.
Berkshire Money Management’s job is to invest based on probabilities, and to prepare for the possibilities.
- The bull market has matured and moved from its “Primary Buying” phase to the next, and more difficult “Holding and Upgrading” phase. The shift from the first to second phase does not typically serve as a warning of an approaching market top, but it is typically characterized by above-normal volatility.
- Our expectation at this time is that over the coming days/weeks/months we will reduce exposure to specific sectors and/or regions, and get broader (more diversified) while staying closer to home (domestic versus foreign).
- Given the extent of the current decline (and the growing possibility of something more severe) classifying the move lower as a correction rather than a bear market may essentially be a distinction without a difference. But one important thing to keep in mind is prices tend to recover a lot more quickly in a correction than in a bear market, with less time spent base building.
Probabilities vs. Possibilities
Following the worst May since 1940 for the Dow Jones Industrial Average and since 1962 for the S&P 500, and with the unofficial Memorial Day summer kick off behind us, the stock market appears poised for a summer rally. Whether that rally lasts the entire summer is another question. But the good news is that there is no shortage of evidence that the spring correction is due a summer bounce.
Equities have now experienced their biggest sell-off since the bear market bottom of 2009, over twelve percent on a closing-price basis (bigger than the seven percent pullback in July 2009, and even bigger than the nine percent drop in February 2010). And this stiff correction has produced the most market fear since then. The excessive pessimism itself supports the prospects for renewed rallying. And so have other milestones achieved during the sell-off, all equity friendly:
• The lowest 10-year Treasury bond yields and global composite ten-year yields in more than a year.
• The lowest crude oil prices since October.
• The strongest volume uptrend in more than a year.
As explained in the May 16, 2010 article “Disruption of the Primary Trend”, conditions were much worse a year-and-a-half ago than they are today. Unlike today, the stock market was battling both an economic recession and an earnings recession. We wrote in May that:
“Instead of contracting, as it was in the fall of 2008, the economy is now growing. Further, instead of failed legislation and failed banks in the fall of 2008, we now have $787 billion worth of stimulus spending and mergers & acquisitions. Instead of bank runs, we now have expanding credit. Instead of losing a half million jobs per month, a half million jobs were created over the last two months. Instead of a temporary cultural shift of shunning excess, we now have Apple selling one million iPads even before consumers fully know what the product is.”
The only thing that has changed from that above statement is that Apple has sold another million iPads.
We never present just one side of the story though – Berkshire Money Management’s job is to invest based on probabilities, and to prepare for the possibilities. And, as detailed in the May 25, 2010 article “It Is Different This Time” (a tongue-in-cheek title), we are preparing for negative possibilities. We cited specifically concerns over North Korean saber-rattling, but we are certainly weighing the possibility that the fundamental picture could worsen if confidence drops decisively in Europe, followed by a drop in trade, production, and overall economic activity.
If evidence mounts (that is, if possibilities become probabilities) that the April-May decline was the start of a global bear market and the precursor of a broad economic downturn, we will do what we have done before and get more defensive. Our current view, however, is that the correction has been an overreaction to the debt crisis – a swoon driven by sentiment rather than substantial deterioration in the global economic and earnings outlook. A global bear market does not appear imminent, nor does more than a modest slowdown in global growth.
(Lest you believe that we are towing the typical “buy-and-hold-no-matter-what” line that other financial consultants like to propagate, remember that not only did we hold pretty much all cash for client portfolios in 2001-2002, but we began to short the market in November 2007. And even if we end up being wrong in any analysis, we acknowledge that what the market does is vastly more important than what we think it should do. We have no problem changing our minds and changing portfolios.)
As earlier indicated, while a Summer Rally is likely there is concern regarding whether it will last the entire summer. Signs of a sustainable, high quality advance would be broad breadth (many stocks participating) and high & rising volume (continued increase of buying interest). If we do not see these prerequisites, and the rally appears to be low in quality, then any renewed rally that pushes optimism readings higher would warn of another correction into the third quarter (thus the correction in its entirety could last five-to-six months). This type of weak rally would signal an opportunity to reduce equity positions as stocks ticked higher, as opposed to selling into a deteriorating tape.
Holding & Upgrading
We predicted that the market could go “down to 1,085-points on the S&P 500” in our April 4, 2010 article “Second Quarter Outlook for the Economic Outlook for 2010. But, as you know, the intent of that call was not to forecast a correction, although we broadly did raise some cash in mid-April (we can write at any time that a correction is coming and we’ll always be right since, on average, there are three-and-a-half five percent corrections and one ten percent correction per year). Rather, the nature of that discussion was to highlight that the bull market was maturing and that it would be moving from its “Primary Buying” phase (where you can pretty much buy anything and get away with it) to the next, and more difficult “Holding and Upgrading” phase. And by difficult, not only do we mean in terms of emotionally digesting the volatility, but also in regards to keeping risk low. We wrote in that article:
“While the primary uptrend of the overall market would remain up in this phase, the stock market can shift back and forth between these two zones, or phases, multiple times before a major top is reached.
Because during this period Buying is more selective and profit-taking is more prevalent, the markets can vacillate between going nowhere and going down (think correction of a 5-10% magnitude). It is worth emphasizing that this second phase can persist for an extended period of time (think 3-7 months). Thus, the shift from the first to second phase does not typically serve as a warning of an approaching market top. The shift does, however, suggest that a premium be placed on selective, rather than broad-based, buying and that cash should be recycled from the weakest investments to stronger positions.”
Our expectation at this time is that over the coming days/weeks/months we will reduce exposure to specific sectors and/or regions, and get broader (more diversified) while staying closer to home (domestic versus foreign) – which we broadly did in mid-May, after the now infamous May 6th “Flash Crash”.
(For more on this Upgrading Phase please see “A Supplement to ‘Disruption of the Primary Trend.)”
What Happens for the Rest of The Summer?
Given that the market had declined below our expectation of 1,085-points on the S&P 500, we are tightening our outlook and strategy, at least at the margin. While our overall strategy (for example, to be “growth & income” oriented) might be designed for the longer term (longer than one year), our defensive strategy (for example, raise the allocation of cash by five-to-fifteen percent) currently only gets us through summer and fall.
Our indicators argue for another rally before any further significant correction (below recent lows). But even so, this correction is expected to be choppy and extended, likely spanning into third quarter of 2010. As mentioned above, once the market is again in rally mode, we would be watching a number of indicators (breadth, volume, sentiment) and likely neutralizing our sector positions. As a “stop-loss,” however, we will turn on that “looking for a rally strategy” if the tape deteriorates.
A Supplement to “Disruption of the Primary Trend”
Our recent White Paper “Disruption to the Primary Trend” categorizes the current pullback as a likely buying opportunity, as opposed to the resumption of a new bear market. This supplement is meant to be read after first studying the more general “Disruption to the Primary Trend” as this piece more specifically details the rationale behind Berkshire Money Management’s preference for certain specific asset classes of the domestic equity market. More precisely, our emphasis is mid-cap stocks, and large-cap Value stocks (especially those with an emphasis on dividend payments).
Mid-cap stocks (typically defined as a company with a stock market capitalization between $2 and $10 billion) are relatively sensitive to interest rates and the economic environment. They stand to benefit from the Federal Reserve keeping rates low “for an extended period” as well as continued improvement in economic conditions. And their high betas (i.e. sensitivity) will be an advantage when the market rallies.
Mid-cap stocks are a proxy for investing in an improved economic recovery where three quarters of consecutive growth in U.S. GDP and over a half million jobs created in the past two months is a good indication that there will be no “double-dip” recession.
“Value” stocks tend to be more sensitive to economic conditions than “Growth” stocks. This is because investors expect earnings of Value stocks to be positively correlated with economic growth, and they expect earnings of Growth stocks to be less sensitive to economic conditions and more dependent on variables such as product line enhancement and mergers & acquisitions.
However, Value is not always an “early cycle play”. In fact, Value has tended to do best once conditions have indicated that the economy is healthy. Following are some conditions under which Value has tended to outperform Growth:
• The economy has been expanding rapidly, since Value stocks tend to be more cyclical than Growth stocks;
• The yield curve is steep, implying that the Federal Reserve is accommodative;
• Credit spreads are wide, implying that investors have already priced in bad news about the economy; and,
• Commodity prices are rising, also reflecting a strong economy.
Also attractive is that cash holdings by Value companies are close to a historic high and, so too, is free cash flow. Of the companies boasting the highest levels of free cash flow relative to market capitalization (positioning the companies for growth and their investors for higher returns) 16 of the top 20 are in the Russell 1000 Value Index.
• Dividend Payers
An additional benefit to Value stocks, especially large-cap Value stocks, is that dividend payouts tend to increase faster than those of Growth companies. Recently, first-quarter earnings have encouraged more companies to raise their dividends (a welcome sign that American businesses are more confident in their prospects). In April alone, 25 members of the S&P 500 index raised their dividends (over one hundred year-to-date), and one initiated a dividend. That is a big improvement from a year ago when just fourteen such companies raised their dividends, and ten actually cut their payouts.
A lot can be said for compounding returns of dividend payments over the long-term, and that math is undeniable. However, in the intermediate term, when we are expecting more subdued stock market returns (see the “Year Number Two” section of the “Second Quarter Update for the Economic Outlook for 2010”), and the yield of dividend payers is much more attractive than the yield of 1.32% for the Russell 1000 Growth Index.
Also, these dividend payers tend to have a more solid balance sheet than their peers. Dividends offer reassurance in an uncertain world.
Bottom Line: It should be emphasized that, by themselves, the strength of the downtrend and potential for further near term losses does not qualify the current decline as the start of a bear market. Thus far, the 15% drop in the S&P 500 (using daily highs, not daily closings) falls within the parameters of a market correction—a severe market correction without question, but still a correction. To justify classifying the current decline as a bear market requires rationalizing why none of the indications that have preceded every major market top over nearly the past century were present prior to the April rally high.
Often the simplest explanation is the correct explanation. And, in this case, the simplest explanation is the current decline represents a correction within an ongoing primary uptrend. But, given the extent of the current decline (and the growing possibility of something more severe) isn’t classifying the move lower as a correction rather than a bear market essentially a distinction without a difference? Perhaps. But one important thing to keep in mind is prices tend to recover a lot more quickly in a correction than in a bear market, with less time spent base building. It might be too easy to dismiss a strong rally as just an advance in a bear market when, in fact, it represents the start of a new upleg in the primary uptrend.
And, since there were no indications of a major top prior to the April 23rd peak, the probabilities suggest a resumption of the primary uptrend should eventually lead to new rally highs. (Think in terms of months, as in the follow through rallies of the 18% declines of October 1990 and August 1998, as opposed to years as in the five years of stock market repair following the 2002 bear market).