October 12, 2008
- To state the obvious, the tremendous panic selling of last week has dramatically increased the probability of a cyclical (i.e. short-term) bull market rally.
- A new cyclical bull market would not rule out the continuation of the secular (i.e. long-term) bear market.
- Technically speaking, the traditional “bottom indicators” metrics of today are stronger than they were even at the bottom of 2002.
- Fundamentally speaking, it was (relatively) easy for Berkshire Money Management to pick the very bottom of the 2002 bear market (to the day) because the technicals were coincident with our expectation of improving fundamentals. Today, picking the bottom of the bear market is tremendously more difficult due to 1) weaker expected global growth in 2009 compared to 2003, and 2) confusion regarding the expected efficacy of government intervention in global credit markets.
- Berkshire Money Management remains cautious in regards to increasing equity exposure. We acknowledge that our caution may result in clients not participating fully if this is, in fact, the bottom of the bear market. However, we believe that currently risk management takes priority; discretion is the better part of valor.
On September 22, 2008 we posted an article on www.BerkshireMM.com titled “A 10-Day Pause, a 4-Month Rally, A Lifetime of Higher Taxes, and Difficulty for the Economy in 2009.” Regarding the segment referring to a likely possibility of a 4-month rally, I cited that “the immediate implications suggest a tradable rally that will last into 2009.” I took some phone calls from our more aggressive clients who urged me to “play that rally.” I resisted and pointed out that the article also said:
“Considering stock market valuations as well as that this bear market having been only about half as intense as other lengthy bear markets, the probabilities do not support the start of a new bull market from this week’s low.
On the subject of valuations, the stock market is, admittedly, fairly valued. However, during bear markets stock prices overshoot to the downside and bring valuations to discounted levels.”
In other words, the probabilities favored a 4-month rally, but not the advent of a new, multi-year bull market. Fortunately, after seeing the Dow Jones Industrial Average (DJIA) fall about 2,500 points from writing that aforementioned article, we resisted the temptation of greed. As we wrote then, and as we wish to reiterate today, we fully expect to miss the bottom of the market. And also as we wrote then, this may sound like a “wimpy stance,” but there is sound prudence behind it.
We have a new section on the homepage of www.BerkshireMM.com called “Useful Website Videos.” Our latest addition is a video called “Charting Double Bottoms.” (You can also view the video by entering the following directly into your address bar: http://www.cnbc.com/id/15840232?video=884072139&play=1).
The video is a useful addition to what we have been telling clients who have called in. Specifically during those conversations we like to refer to the historical average of bull market runs following bear markets. Since World War II, the average bull market that follows a bear market lasts 46-months and advances the DJIA by 123%. So, as we have been telling clients, we would be comfortable missing the first 1-, 2-, or 4-months or first 5-, 10-, or 20% rally because if we were truly at the very bottom of a bear market, then we would not only have several years to participate in a bull market, but also an opportunity to just about double the portfolio.
The video further enforces that we investors should resist one of the most powerful of all human emotions – greed. We, as profit-maximizing investors, desire the impossible – to get out at the top and to get in at the bottom. Investors do not often want to believe that is impossible, but it is impossible – at least to do so reliably and accurately it is impossible. But if investors are overwhelmed by greed and feel compelled to chase any rally that we see from here, it is important to note that significant bottoms are just about always retested; so you’ll have a second chance.
Said another way, at meaningful stock market bottoms, after rebounding 15-25% (which us profit-maximizing/greedy investors would hate to see pass us by) will usually experience a drop down to its prior low (aka “retest the low”). Currently, it appears as if a bottoming process is underway. But those bottoms are typically tested. And if that testing process is followed by a broad-based advance that brings significant improvement to our indicators, we will likely be buyers of equities.
So if we do get a rally and we let a good chunk of it slip by, do not think us wimpy or slow, but rather prudent. (and perhaps even knowledgeable of the markets). After all, a new cyclical (i.e. short-term) bull market would not rule out the continuation of the secular (i.e. long-term) bear market. Our approach in experiencing any rally right now is to follow the tape closely and to see if the lows are tested successfully with light selling or, in other words, weak volume.
THE RESEARCH AND THE STRATEGY
This has been a period of great confusion for most investors trying to absorb all of the information, the lack of information, and the dis-information coming from every direction. In the end, investors (professionals included) can only guess where the free market, the proposed economic panaceas, and the politics will take our economy and the stock market over the next six or twelve months, or even longer.
But, good professionals should attempt to minimize guesswork in your portfolios. In times of confusion, professionals must find a way to make portfolio decisions based on unbiased information and tangible probabilities (as opposed to possibilities). Beyond the confusion of today, the ultimate driver of stock market prices is the same as it has ever been – the forces of Supply (selling) and Demand (buying).
We know that in the past year, the desire to sell stocks has dominated investors’ buying interests. And while I was merely an average student in physics (and that’s probably being a little generous), I do remember that Newton’s First Law was that a trend in force tends to remain in force until something occurs to change it (true students of physics will have to forgive me if I am torturing this analogy). Thus far, we have not seen any tangible evidence (i.e. buying interest dominating selling interest) of a change to the trend of the past year.
On a short-term basis, the evidence is compelling that the market is at, or very close to, (at least) a short-term bottom. Yes, we cited the same 2,500 DJIA points ago. To state the obvious, a much lower stock market enhances the probability of a short-term jump in stock market prices through the end of 2008 and into 2009.
Indeed, the bottom evidence has become even stronger than it was around the 2002 bottom when we brought our clients from an almost all cash allocation to an almost fully-invested equity allocation. So, as markets have spiraled to lower lows, the case for a bottom has strengthened. Even so, we must consider two things. First, there is no telling just how negative the sentiment or the numbers will become before they reverse. Second, it was an easier answer for us to pull the proverbial equity-trigger in 2002 because we properly forecasted stellar global economic growth for 2003. For 2009, we are not nearly as optimistic about global economic growth.
As such, nothing has yet occurred to take us away from our current defensive positions. We may be very close to the bottom of the bear market, but the past week has demonstrated that trying to buy close to the bottom of a bear market can be a very dangerous strategy. Disciplined patience is still the key to survival in this bear market. We may be closer to the start of any significant rally than we have been in the last year, but that does not necessarily mean that the bear market is over or that a new bull market will promptly begin. The market is certainly “oversold,” but oversold is a relative term, and the market can get more oversold in the days, weeks, or even months ahead.
I admitted early that I was not a great student of physics. Too, I wouldn’t argue that I was a particularly impressive student of history. But with history we can all cheat by simply looking back to reveal the three essential elements to every important market reversal:
First, the desire to sell must be exhausted. As suggested earlier in this article, stock prices follow the Law of Supply & Demand. So for selling to be exhausted, selling must have reached the panic stage in which everyone who wants to sell has done so. This eliminates the overall supply of available stock, which itself drives down prices. Given the intensity of last week’s sell-off, there is sufficient evidence to support the argument that selling is exhausted (thus improving the probabilities of a stock market rally).
We believe that the first element has been satisfied at least to the extent so as to expect a strong and significant rally.
Second, the intense, panic selling must drive stock prices down to discounts deep enough to attract broad buying enthusiasm, not just for short-covering or bargain-hunting, but for long-term accumulation.
In terms of discounted stock market prices, if you rely on the consensus Wall Street estimates (a prediction of a 22% advance in earnings in 2009 over 2008 for S&P 500 companies), then the forward 12-month price-to-earnings (P/E) ratio (using “operating earnings” numbers) is an extremely attractive P/E of 9. However, we must reflect upon the definition of “operating earnings” to fully appreciate the risk of using these popular numbers. According to Investopedia.com, operating profits are “profits after subtracting expenses such as marketing, cost of goods sold, administration and general operating costs from revenue.”
Does that sound suspect to you? It should. It is painfully reminiscent of the “pro-forma” numbers used during the tech-bubble to re-engineer metrics so as to convince us favorable valuations. Using, in my opinion, more appropriate “as reported” numbers (which are more akin to Generally Accepted Accounting Principles, or GAAP), the 12-month forward P/E is closer to 18.
We do not mean to sound so arrogant as to suggest that we somehow know better and are more properly informed than the collective analysts of all of Wall Street. Admittedly perhaps we are too cynical about Wall Street’s optimistic estimates. Considering such, we continue to view this as, quite possibly, the bottom of this particular bear market.
Nonetheless, right or wrong, we remain skeptical – thus we do not believe that the second element has been sufficiently satisfied. However, the caveat in regards to valuation is that actual buying trumps expected earnings (the tangible trumps the intangible).
Third, the quality of any rally must be carefully monitored. Brief, selective rallies (like the ones from mid-November 2007, late-January 2008, mid-March 2008, or mid-July 2008) lasting from a few days to a few months followed by heavy selling is the sign of a “Sucker’s Rally” that plays upon investor’s greed and sucks them back into the market before it, again, drops to lower-lows (as opposed to a successful re-test).
Of course, this element cannot be judged until after-the-fact. However, any rally without these positive signs should be viewed as another opportunity to sell into strength.
The Bottom Line: Technically speaking, from these levels the ideal scenario to demark this as a bottoming process and the advent of a brand-new, multi-year bull market is that 1) the stock market rallies on good breadth and good volume and brings the market up 10-25% over the next weeks or months, and 2) the stock market falls back to retest its recent lows and does so on very light volume.
Fundamentally speaking, the mass of confusion regarding restoring the health of the credit markets and thus improving the prognosis for global growth argues that, regarding moving from cash to equities, discretion is currently the better part of valor.
I am personally loathe to find myself using such an extraordinarily overused financial cliché, but the marriage of technicals and fundamentals makes me “cautiously optimistic.”