Research & Advice

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What We Are Watching

August 11, 2011

 

  

  • The stock market experienced what is referred to in the industry as a "Waterfall Decline".  The stock market’s actions after such a decline often can be resolved violently to the upside, but not always.

  • The stock market’s internals (breadth, volume, etc) will be especially important in giving hints as to whether or not the stock market has reached a level from which a new cyclical bull market will begin.

  • Consistent with our Economic Outlook for 2011 report, Berkshire Money Management will continue to allocate defensive leadership into investment portfolios.

 

The fierce stock market meltdown has reached a potential turning point.  So we’re watching the indicators closely to determine whether the recovery attempt will be a false start followed by another round of carnage, or whether it will mark the start of a bottoming process and a sustainable advance to follow.

It is quite possible that we have seen the selling climax of the decline.  The Monday, August 8th meltdown was the first day in which all of the S&P 500 constituents had dropped for the day, based on data on hand going back to 1972.  On near-record volume, we saw the highest ratio of declining volume to advancing volume since available data going back to 1980.  And the VIX Index (aka the "fear gauge") reached its highest level since the bear market lows of 2009. 

Also at its most favorable level since the market lows of 2009, the median price-to-earnings ratio of S&P 500 stocks is 14.9.  Valuation, monetary, and sentiment levels are all consistent with rational expectations of a significant rally for the market from these prices.  But, again, we are watching for signs that this rally would be sustainable – we will be looking for substantial breadth improvement, for any retest of the lows to occur on diminished downside volume and fewer new lows.  We would then want to see new recovery highs with decisive improvement in trend-sensitive gauges.

We are not expecting a recession this year.  The earnings season has been upbeat, with 70% of the reports surprisingly positive.  Clearly, on a longer-term basis, there is a correlation between profits and stock prices.  However, on a shorter-term basis, this correlation gets turned on its head.  We recognize that longer-term, markets trade on fundamentals. But they also trade on sentiment. 

With the market’s breakdown, sentiment has turned from optimism to pessimism.  A rally to S&P 500 1200-1250 (one-third retracement of the recent decline) would be a reasonable expectation of first upside test.  Perhaps the expectation that the Federal Reserve is willing to execute QE3 (the third round of quantitative easing), or that the European Central Bank will unleash QE1, will spark that rally.  Nonetheless, such a rally may be short-lived, as waterfall declines reflect broken confidence and often don’t include more than a few weeks of rally before a retest.

With the market pricing in concerns over a weakening economy, we will continue to follow the script of our Economic Outlook for 2011 report and use any rallies to continue our ongoing campaign to identify and increase investment allocations toward defensive leadership.

Although we do not expect a recession this year, it is important to keep in mind that a recession in the U.S has historically, on average, occurred once every six years.  The range of time has spanned from less than two years (aka a "double-dip" recession) to about ten years.  The current recovery is 26-months old.  With national unemployment staggeringly high, it would not be beyond the realm of statistical probabilities to hint that a recession could begin within three years from the end of the previous recession (i.e. by mid-2012).  If current stimulus is allowed to expire and is not replaced with new stimulus, the U.S. economy risks flirting with recession.

Bottom Line: The preponderance of market evidence points toward a meaningful stock market rally from these levels.  The reaction of that rally will determine whether or not we use that return of Demand (i.e. buying) to become more aggressive, or more defensive.  Consistent with our Economic Outlook for 2011 report, it seems more likely that we will continue to allocate defensive leadership to investment portfolios.