Saturday, November 01, 2008

• Global stock markets crashed in the first part of October, but rallied impressively in the last week and moved closer to re-testing its recent highs (1,045 on the S&P 500).  We believe it is likely the stock market is bottoming.  However significant risks remain as to the durability of this rally.
• Should those risks dissipate, we could begin purchasing new investments in as soon as a month or two.  As such, we have began compiling a list of asset classes we would expect to perform well should the global markets begin to improve.
• Fundamentally, the U.S. economy is deteriorating.  This frustrates the application of valuation metrics and makes investing a more risky venture than is typical.
• Technically, it is too early to say with confidence that October 10th was the initial low and that October 27th was a successful re-test of that low, which would mark the advent of a brand-new, multi-year bull market. 
• Given the sour fundamentals and that an “oversold” market can get more oversold, it would be prudent to hold off on acquiring new equity positions so as to watch and measure additional evidence that any new lows from this point are of a fairly limited nature (as opposed to another multi-year bear market like 1968-1970, 1973-1974, or 2000-2002).

There is no doubt that the equity markets have become dramatically oversold.  The MSCI World Index had dropped 48% for the year.  The average professionally managed mutual fund (including “safe” bond funds and bear-market funds) was down 15.98% year-to-date through September 30th (before the October crash).  The smartest and most successful investment managers on the planet are liquidating their hedge funds as their returns have crushed their client’s life savings.  For its part, the Dow Jones Industrial Average (DJIA) was down 42% at one point this year, its biggest decline since the bear market of January 1973 to December 1974.

But when thinking about buying more equity in the months to come, all of this bad news could be good news.  Before you think that we have turned to optimistic from cautious, know that we are still cautious and we will highlight that caution later in this report.  But the good news is that our view of caution is an “upgrade” from the pessimism that caused us to drive equity positions from client portfolios all year long.

Later we will also get into what we are looking for before we turn from cautious to optimistic, but first we wanted to share with you some of the ideas we are placing on our potential buying list.

Buying list

Emerging Markets.  We would look to accumulate dramatically undervalued assets.  Even before the October crash, emerging markets were cheap.  And if we embark on a new global bull market, then the high-beta (1.36) tendencies of this asset class would make it an attractive investment. 

It is important to note that when credit spreads (as defined by the difference between corporate bond yields and Treasury yields) have spiked in the past (such as in 1987, 1990, 1998, and 2002), that has been coincident with a global market bottom.  That spread had spiked in recent weeks, and in each previous case emerging markets have outperformed as the new bull market gained momentum. 

Small-caps.  Like emerging markets, small-caps are also high-beta (1.23).  And like Emerging Markets, Small-caps tend to perform well when credit spreads are high and dropping.  Importantly, they tend to out-perform after market bottoms and begin to do so before the ends of recessions as they anticipate an economic recovery. 

NASDAQ.  Also high beta (1.33), the NASDAQ Composite would be another likely outperformer after a bottom.  While the S&P 500 and the DJIA have usually bottomed at the same time, the NASDAQ has had a tendency to lag – its lowest close has lagged the DJIA’s lowest close in five of seven cases since 1982.  But once the NASDAQ has bottomed, the snap-back has been substantial, with the NASDAQ tending to out-perform over the subsequent three-month and six-month periods.  Accordingly, the Information Technology sector, the sector most dominant in the NASDAQ, has had the highest beta (1.42) among sectors and highest returns after bottoms.

Commodities.  Investor speculation in this asset class has been replaced by excessive pessimism.  The secular theme of reflation and China-driven commodity demand is still intact and likely to reassert itself given the massive global monetary and fiscal stimulus, negative real interest rates, and the commodity correction’s positive implications for future economic growth. 

Junk Bonds.  The outlook for corporate debt has vastly improved.  Better valuations and a possible stock market bottom all factor into our upgrade of this asset class.  Corporate spreads have hit levels that have not been seen in years.   Given the speed and the size of the policy responses to address the financial crisis (both fiscal and monetary), the odds favor a significant reversion to the mean.

So once we are able to confidently call a bottom, we’ll be able to expect relative strength from emerging markets, small-caps, the NASDAQ, and commodities.  Junk-bonds would not likely be as big relative gainers, but we like their inclusion for the purpose of diversification (you can include preferred stocks in that category as well).  And that out-performance would itself be additional confirmation that the bear market bottom had been reached. 

Fundamental Caution

Regarding calling a stock market bottom, much of our reported work as of late has been in the context of Supply (selling) and Demand (buying).    In the investment industry we refer to those as “technical” measurements.  But to be certain, the bulk of our work is fundamental, not technical.  Many technical indicators have become extremely bullish as of late.  These are the same bullish technical indicators that allowed us to confidently and correctly begin aggressively buying equities six years ago in October 2002.  But the difference this time, as opposed to our forecast for 2003, is that the fundamental remains quite sour.

Although last week’s 0.3% drop in Gross Domestic Product (GDP) was less severe than expected, we believe that the economy is deteriorating as fallout from the financial crisis intensifies.  Of particular concern is that consumption declined 3.1% annualized in the third quarter, its first decline since the 1990-1991 recession and the largest drop since 1980.  Weakness in spending was broad-based, affecting both durable and nondurable goods.  This knocked 2.3 percentage points off of GDP.  The outlook for spending has darkened as rising joblessness, declining wealth, and slower income growth hit household budgets. 

There are obviously other areas of concern (commercial real estate, in particular, comes to mind:  a weak economy has pushed up vacancy rates, tight credit conditions are making it difficult to obtain commercial real estate loans, and financial returns on commercial properties are much lower).  The financial crisis continues to restrict the flow of credit through the economy, leading consumers and businesses to cut back.  The U.S. economy will remain in recession with GDP contracting significantly this quarter and into 2009.  The questions, of course, that need to be answered is how far into 2009 and what, ultimately, will a recovery look like.

This gives us hesitation in our intent to put cash to work back into equities.  We would need to see a decrease in the rate of economic deterioration before becoming more aggressive in purchasing equity.  Until then any projections of corporate revenue and earnings are, at best, guess work.

Technical Caution

In the “Watch the Rally With Suspicion, Not Greed – Parts I & II” articles we detailed the idea that even if October 10, 2008 was the low for this bear market that we would likely revisit those lows in what is called a “re-test.”  Last week the major stock market averages jumped over ten percent.  Given that incredibly impressive surge, it is important to review last Monday, October 27th as the possible date of a successful re-test.

Re-tests typically take about two months (the most recent one took five months, in March 2003 following October 2002).  If October 27th was the re-test of October 10th, to say the least for such a re-test to occur in just 11 or 12 trading days does not fit conveniently into historical expectations.  Typically that would not be of utmost significance as stock market history usually only rhymes, it does not perfectly repeat.  However, given the backdrop of deteriorating fundamentals we would certainly feel more comfortable if we were handed that more convenient replay.

The closest parallel we can find to what is occurring with the market right now is 1987.  We are careful, however, to note this is not a template to follow.  Consider the historical similarities.

1. The stock market crashed 22% on October 19, 1987

The stock market crashed 22% from September 30, 2008 through October 10th.

2. In 1987 there was an immediate three-day 15% rally following the crash.

In 2008 there was an immediate three-day 24% rally following the crash.

3. After the three-day rally in 1987 the stock market re-tested its lows three trading-days later.

After the three-day rally in 2008 the stock market re-tested its lows nine trading-days later (October 27).

4. After the 1987 re-test the stock market rose 12% in eight trading-days.

After the 2008 re-test the stock market has (so far, through October 31) risen 11%.

What happened next in the 1987 scenario?  The stock market’s advances petered-out and made its final re-test in early December. 

Again, it would be imprudent to use 1987 (a single-case scenario) as an analog to 2008.  It is worth noting, however, that whether the market follows this singular case or other similar cases, the S&P 500 will likely climb back toward 1,045 points over the coming weeks. 

But 1987 was recent enough for most of us to remember, so hopefully it helps to reinforce our concern that such an immediate re-test may not hold.  But our greatest concern, of course, is not being a little too early or a little to late, but rather that the stock market will fail, not pass, its “test” and thus the stock market will breakdown to lower lows.

Admittedly, our concerns may very well be ill-placed.  After all, as indicated above, the stock market is dramatically oversold.  Many of our indicators have dropped to levels coincident with major market bottoms over the past sixty years.  However, “oversold” is a relative term; a cheap market can get cheaper.  Recent examples of an oversold market getting more oversold occurred this year in January, March, and July.  Therefore, with the very limited amount of evidence available over the past week or two of trading, it is simply too early to make an accurate determination as to whether or not the current rally is the start of a major advance or just another rally within a continuing bear market.

Bottom Line

One of the intriguing features of stock market investing is that there are always large groups, made up of novices and professionals alike, who seem to really believe that there are ways of accurately identifying the exact end to major stock market trends.  Yet, those same people clearly know that such accuracy is not available in any other form of human endeavor.  Everyone knows that it is risky and impossible to identify, with precision, the first snow of Winter, or the first thaw of Spring. 

It is more prudent to watch the evidence build over a period of time.  Typically, bull markets last roughly 46-months and advance the DJIA by 123%.  Giving up, say, ten months of market gains as insurance against making a big mistake would still leave 36-months (three-years) of bull market gains.