Sunday, October 19, 2008
- During the past week the list of “experts” attempting to gain their fair-share of media attention have come out to claim, definitively, that the bottom is in or – on the other side of the spectrum – that stocks are going to crash further. Opinions are exciting however, Berkshire Money Management falls into the camp of those rare few who say that there is simply not yet enough tangible evidence at this point to justify major portfolio changes. We’ll know much more in the weeks and/or months to come.
- Discretion remains the better part of valor, but it may be only weeks before we move from defensive allocations and toward growth
The previous week experienced the biggest Dow Jones Industrials Average (DJIA) gain in five years, the biggest DJIA day in points gained (936), the second biggest DJIA day in points lost (733), and saw a 24% stock market rally from the lows of the prior Friday (October 10th) to the highs of the subsequent Tuesday (October 14th).
That last comment gets lost in the chaos of the last couple months so please allow me to repeat: the stock market rallied 24%.
The sustainability of that rally and any follow through which may occur remains suspect, although there is mounting technical evidence (even if the fundamental evidence is not yet piling up) that the bottom is in for this bear market.
As discussed in the Sunday, October 12th article (Part I), lows in the market are typically “retested.” And this past Thursday (October 16th) may (emphasis on “may”) have been the day of the re-test.
It is important to note that bear markets end with a whimper, not a bang. The low made on Friday, October 10th was a “bang” in so much that it was dramatic not only in terms of points lost, but also that the day experienced twice the average volume. This is bullish in that it signals a panic-bottom that washes out sellers.
For those interested in some details behind the whimper/bang description, consider that the “bang” day in question was also significant in that the number of stocks in the S&P 500 and listed on the New York Stock Exchange (NYSE) made a higher percentage of new 52-week lows. Again, that’s the “bang,” and bear market lows don’t typically end in a bang, they end in a whimper.
The “whimper” has less to do with the level of stock market indices and more to do with how we get to those levels. So the whimper-low can be higher or lower than the bang-low. After the bang-low you should expect a significant rally, and then for the market to pull back to similar levels only to make its final low as the number of 52-week lows actually contracts.
The “bang” day set up “a” low, but not necessarily “the” low that marks the beginning of a new, multi-year bull market. After reaching the recent high on Tuesday, the stock market hit a “whimper” bottom on Thursday as it slid 13% and re-tested the closing lows of Monday, October 10th. A 24% rally and a subsequent 13% correction represent huge and volatile numbers – the fact that they largely went unnoticed by investors is perfect anecdotal evidence of a “whimper” low as opposed to October 10th when the world woke up to a “bang.”
However, to be certain, a whimper re-test of a bang-low typically occurs many weeks to several months later. The enormous movement within the confines of one-week is unusual duration for a successful re-test. Consider that 300+ point rallies in the DJIA are common during bear markets. There were 16 such instances during the 2000-2003 bear market. In contrast, during the 2003-2007 bull market there was not one instance when the DJIA gained 300 or more points.
Up until October 10th, 2008 there had been eleven 300+ point days since July 2007, and then two more in just the last week (Monday and Thursday) to bring the total to thirteen. Therefore, although the re-test fit the “whimper” characteristics we were looking for, its extremely volatile nature (as well as its condensed duration) seems to be insufficient evidence on which to establish new equity positions.
The 936-Point Gain
In the Sunday, October 12th article we also noted that not only were we looking for a successful re-test, but that we were also looking for a resurgence of demand (i.e. Buying interest in stocks that overpowered selling interest). Monday’s 936-point gain on the DJIA was a perfect example of resurging demand. Still though, we remain skeptical.
I know what you are thinking: We look for a re-test, we get it, and we remain skeptical. Then we look for a resurgence of demand, we get it, and we still remain skeptical.
To give that 936-point jump its proper context, as extraordinary as it was we have to look at what prompted the bounce. The actions of the weekend of October 11 & 12 to bolster the European banking system were extreme. We want to see demand come into the stock market and rally on its own volition, as opposed to the goosing by a $700 billion bailout plan, a coordinated global rate cut, or a G7 rescue pact. We want to see buying by investors because investors believe stock prices have gotten to discount levels.
The key element to a short-term stock market rally being evidence that something more substantial might come over the coming years lay not in the magnitude of the gain but rather in the quality of the buying that propels the advance.
Buying on rebounds from sharp declines, including selling climaxes such as October 10th, is generally of two types. First is investment buying, as buyers scoop up bargains they intend to hold for the long-term. The second type is shorter term in nature, consisting of bargain hunting for short-term profits as well as buying for short-covering. Possibly the best way to determine which type of buying is behind a rebound rally is through the character of any subsequent pullback.
If the buying was of the long-term variety, those who bought stock will typically hold onto it, as short-term pullbacks are of little concern (and thus making a new “whimper” low). Light volume on the pullback would suggest long-term buying had been a factor in the rally.
But if the buying was for a quick gain then supply of stock, through selling, is pushed back into the open market as traders take short-term profit. Heavy volume on the pullback would suggest that stock is being sold for short-term profits.
But don’t get us wrong, this 936-point day was the fifth largest percentage advance and was an impressive exhibit of buying interest. However, even if we are wrong to diminish the value of the re-test and/or the resurgence of demand, the key element lay not in the apparent success of both or either, but rather in the quality of the buying that propels any advance that we may experience.
Risk vs. Reward
So while we prefer to see glaringly obvious signals from the re-test as well as the initial resurgence of demand, neither were so impressive to us that we today feel compelled to abandon our defensive positions and to instead begin buying more equity.
Given that the market rallied 24%, we were right to argue that “a” low was put in place on October 10th. However, the main theme of this article is whether or not “THE” bear market bottom has been reached. If you allow us to get past the math and the statistics and shift toward strategy for a moment, we ask ourselves this question: What are the risks? And there are two primary risks.
The risk of aggressively calling this “the” bottom and to use cash to buy back into the stock market is portfolio losses, and perhaps significant losses at that. Yes, those may only be short-term losses, but a lot of damage can happen in the short-term (witness the first ten trading-days of 2008 or the first eight trading days of this October).
The risk (or more specifically, what we call in the business the “opportunity risk”) of maintaining cash is that perhaps we make less of a return than we otherwise might have enjoyed. Since World War II, the average bull market following bear markets last 46-months and bring the DJIA up 123%. Could it be shorter or longer? Absolutely, this is just an average. But the point is that we could be 1-, 2-, or 4-months or 5-, 10-, or 20-percent late in calling the very bottom of the bear market and we would still have years and scores of percentage points to participate in a new, multi-year bull market.
If, in fact, we’ve reached the bottoming phase of this bear market then it won’t be long (early 2009?) before we are able to confidently buy more equity, perhaps even be fully invested. Over the next two-to-sixteen weeks we will be able to gauge not only if buyers are coming back into the market, but if credit markets are improving, if earnings are coming in better than expected, etc.
However, another bear market downleg will be indicated if the stock market indices break through their recent lows and then plummet further, thus confirming our current defensive positions.
It is our estimation that the risks currently outweigh the rewards. However, that balance, and our associated tilt toward risk management, is primarily due to confusion blurring traditional indicators. It may be only weeks before we move from defensive allocations and toward growth.