Research & Advice

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Uncomfortably Conservative

Wednesday, July 14,2010

 

 

  • In the July 3rd “2010 Mid-Year Update” we explained that “due, in part, to the market’s likelihood to rally from the current level…portfolios are positioned to be ‘uncomfortably conservative.’ …Being in cash is a risky proposition in so much that we are flirting with missing a big part of any big run-up, should the rally prove to be the start of a new bull market.”
  • In that same report we alerted that “we see considerable challenges for the stock market for the third quarter of 2010, which puts us a little more at ease in regards to being ‘uncomfortably conservative’ for at least the next few months.”
  • Berkshire Money Management has never had pride of ownership. Our conservative posture protects us from the Q3 challenges that we have forecasted. If our concerns prove unwarranted and the stock market embarks on what we perceive to be a sustainable rally, we will have little choice but to reinvest cash and participate in said rally.

 

In the July 3rd “2010 Mid-Year Update” we described our current investment posture as “Uncomfortably Conservative.” As we explained in that report, part of that uncomfortable feeling was based on the following prediction:

“Given the market’s current oversold condition, investors should remain alert to the possibility of a six-percent-ish rebound rally up to 1,085-points on the S&P 500 (what was support has now become resistance). There is usually some seasonal strength in early July, and given that the market is oversold there is a high probability of a rally (another nine percent rally, like the earlier one we predicted, would actually bring the S&P 500 back up to 1,100 points).”

 

Right now (after the close on July 13th), the S&P 500 is about 1,095 points – right where we expected.

 

As encouraging as the market action has been, our biggest concern is that the correction has not run its course. The ultimate remedy for this correction may not be prices levels, but time. Whether it is the consideration of higher taxes in 2011, or a battle over November’s US Senate elections, or a withdrawal of stimulus from the global economy, we continue to be concerned about challenges in the third quarter (Q3) of this year. We addressed those concerns in the “2010 Mid-Year Update” as follows:

 

“A quick mention of a Q3 challenge that has, so far, drawn little attention; public data on mutual funds show that they remain fully invested. The cash/assets ratio of stock mutual funds remains elevated (i.e. optimistic) while the public remains skeptical. Mutual funds may need to rebuild some liquidity by selling assets should the public continue to withdraw funds. If you sell a mutual fund it does not hurt the stock market so long as fund managers have cash available for redemptions. But when they have to start selling stocks to satisfy liquidity needs, that is a challenge for stock prices.

 

As the quarter progresses, there are seasonal headwinds that will increase. September has tended to be the weakest month of the year. And our broader cycle composite, which also includes the four-year Presidential cycle as well as the ten-year decennial cycle influences, also warn of headwinds by the end of the summer. “

The philosophy at Berkshire Money Management is to have zero ego. Just because we have outlined what appears to be a logical construct does not mean that the stock market must follow that pattern – it only means that it is most probable that the market will find it difficult to rally in the face of those Q3 challenges.

But it is possible, as always, that the most probable scenario will not occur. After all, if the statistical outcome for a lottery drawing is ninety-percent, that still means it is possible to lose ten percent of the time. We need to always be flexible to those possibilities.

Is it possible that the correction is over?

Given our great degree of uncomfortableness in our conservative investment posture, we have had a great deal of dialogue regarding what we might need to see to move toward something more growth-oriented. Before we address those office conversations, let us reiterate that we balance risks and rewards when it comes to managing investment portfolios. Investment errors tend to come in two varieties. First, an investor can be too aggressive at the wrong time and lose more money than they should have. Second, an investor can be too conservative at the wrong time and simply make less money than they might have otherwise made. Making less money is our preference to losing more money.

Also, should today be the day that marks the beginning to a brand new, multi-year bull market, the worst of the news might be that in the short-term we do not keep pace with an extremely aggressive benchmark (and make no mistake about it – the stock market is an extremely aggressive benchmark; it’s one hundred percent invested in stocks one hundred percent of the time – that’s risky!). However, if it is truly the beginning of a multi-year bull market then, by the very definition of such, we have much time and many returns in which to participate in.

Now, back to the subject of what we might need to see in order to put aside our concerns regarding Q3 challenges and thus become convinced that the primary trend (we do still consider the primary trend to be a cyclical bull market) has renewed itself. It is important to note that if it were not for the occurrence of two 90% Upside Days (July 7 and July 13), we may not be giving this subject as much consideration as we currently are. (As we have written about, a 90% Upside Day is a trading day that meets two conditions. First, upside volume is equal to or greater than 90% of the sum of upside volume plus downside volume. Second, points gained is equal to or greater than 90% of the sum of points gained plus points lost.)

90% Upside Days are bullish indicators as they show that investors 1) have finished selling and 2) want to start buying (remember how important the Law of Supply & Demand is for stock prices; selling is Supply, and buying is Demand). These days must not stand alone; follow through in the rallies must substantiate sustainability. For example, the June rally also had two 90% Upside Days over the first six days of its advance. Instead of experiencing encouraging follow through, the rally ended badly. This more recent follow through is, so far, proving more bullish as Demand has picked up at a greater pace, and Supply has been withdrawn also at a far more impressive pace.

July 7’s and July 13’s 90% Upside Days, complemented by strengthening market conditions, is consistent with the possibility of a renewed rally. However, further work is needed to confirm the market has established a sustainable bottom and that the primary trend is indeed reasserting itself. Specifically, a sustained move above the June 21st highs (1,131 on the S&P 500) on respectable volume would go a long way in confirming the correction dating from the April peak has run its course.

 

No Ego, Just Discipline

It is worth repeating, we at Berkshire Money Management have no ego. For literally centuries, investors of the caliber of Nobel Prize winning economists have tried to consistently outpace the returns of the overall stock market. So have mutual fund managers as well as our competitors. The only thing that has consistently occurred is the failure of investors to achieve this lofty goal. We would be fools to think that we could be any more lucky (although we have been very lucky this year, and last year, and the last nine years; come to think of it, the harder we work, the luckier we get…).

We believe the Q3 challenges are real. However, the stock market could easily prove us wrong. Skeptical though we may be, our discipline will be to reinvest cash on continued strength of the stock market. Perhaps not all at once, but we could begin that process.

Our discipline helps us participate in bull markets. Conversely, in the 2010 Mid-Year Update we discussed our discipline as it pertains to preserving the value of your portfolio:

“While we strive to be proactive in raising some cash prior to market tops, we also recognize that an overvalued stock market can continue to get overvalued (take, for example, the three glorious years of stock market returns you might have missed by going to cash in 1996 – the year of ‘irrational exuberance’)…When times are bad we get more conservative; when times are good we get more aggressive.

 

For example, in November 2007 the S&P 500 hit a high of 1,576 points in November 2007. On November 20, 2007 we posted an article on BerkshireMM.com titled ‘Cut and Run at 1,438’. A few months later we posted a similar article titled ‘Cut and Run at 1,312’. The numbers 1,438 and 1,312 referred to levels on the S&P 500 – odd numbers to be sure, but they had some level of technical relevance to us at the time. “

 

And just as levels on the S&P 500 have relevance on the downside, they also have relevance to the upside.

 

A Quality Pullback

 

Relevant as any further advance may be, so too is the quality of any near term pullback. The extended nature of this rally has left the market over-bought and vulnerable to profit-taking. Keep in mind that after the second 90% Upside Day of the June rally, the stock market spent the next four trading days struggling to extend their gains, finally succumbing to a 90% Downside Day on June 22nd.

 

A similar struggle to advance over the next few days would suggest that the market could be vulnerable to another spike lower. A pullback on light volume would be a positive sign for the market, as it would suggest that despite the recent rise in prices, potential sellers are holding onto their shares in anticipation of a larger rise. A low volume (i.e. high quality) pullback implies a greater potential to remain durable as it describes recent buyers as accumulators of stocks for the longer-term, as opposed to a simpler June-like rebound rally off of oversold levels.

Bottom Line: Even for us investment pros, it is uncomfortable being invested conservatively when the stock market is rallying. But it is clearly better than the alternative. We prefer to be out of the market wishing we were in, than in the market wishing we were out.

On July 3rd we acknowledged that we were uncomfortably conservative because “there is usually some seasonal strength in early July, and given that the market is oversold there is a high probability of a rally (another nine percent rally, like the earlier one we predicted, would actually bring the S&P 500 back up to 1,100 points).” Admittedly, just because we predicted that rally doesn’t do much for making us feel any less uncomfortable holding cash, even if it is just short-term pain.

For Berkshire Money Management to determine that our concerns over Q3 challenges are overblown and that the correction dating from the April peak has run its course we must see continued and strengthening Demand for stocks, in the form of increasing volume, as the market continues to improve and ultimately sustain higher highs.

Important Note: We absolutely hope that we are wrong! We prefer that the correction is over and we now have to play catch-up in getting invested once again. There is a difference between being right and making money – it’s more important for us to make you money.