January 23, 2008

When everyone is looking one way, we miss what is happening the other way.  In terms of the stock market, when everyone is expecting something to happen, something else happens.

I am talking about contrary opinion and investor sentiment.  Essentially, the premise of contrary investing is that it is very bullish for the stock market when everyone feels very bearish. It really isn’t a “smart money/dumb money” thing; it’s a supply/demand thing.

The concept is that if, as an investor, you wish to identify turning points in the market, then you look for the majority opinion to reach an extreme and then you assume the opposite position.  Looking back over history, almost by definition a top in the market is the point of maximum optimism and a bottom in the market is the point of maximum pessimism.

For example, think back to 1999 when the price level of the S&P 500 was valued at about 32 times earnings (FYI – we have not gotten much past half that level in this cycle).  Investors were unreasonably optimistic about earnings growth and inventory levels and became insatiable in the amount of stock that they could hold.  More anecdotally, there were swarms of new, in experienced investors bragging about the riches they were making in stocks.  That’s probably always going to be a bad sign.

Said another way, at points of extreme optimism, everyone who wants to own stocks, owns stocks – demand cannot meaningfully increase.  When the stock market rises investors jump into stocks, they become fully invested and shrink liquidity, the market becomes overbought, there is nobody left to buy stocks, and the market will not go any higher. 

On the other hand, at points of extreme pessimism, everyone who wants to sell stocks, has sold stocks – supply cannot meaningfully increase.  When the stock market falls, investors get out of stocks, liquidity rises, the market would become oversold, there is nobody left to sell stocks, and the market will not go any lower.

In the January 20th “Following the Lead” article on www.BerkshireMM.com, with the S&P 500 closed over the weekend at 1,325 points, I wrote “at these short-term oversold levels of the market, it would be reasonable to expect a rally from either these or near levels (1,300-1,275 points).  So while I am not opposed to reducing beta right now (i.e. selling equity), there is the likelihood of a rally from these levels.” 

The market opened today at 1,310 points, extremely close to our Outlook 2008 risk level of 1,300 points (or at its 36-year median P/E of 16.4).  Admittedly, I was caught off guard that it only took three weeks to get there (I was thinking three-or-five months, not weeks).  But now that we are here, and I do not like being here, I have to make decisions that best serve clients.  Broadly, the question of portfolios and how to best serve clients is, as it pertains to equities, do I sell or do I buy?   Contrary opinion argues that we buy.  Here’s is the data:

• The four-week moving average of net bullishness, as surveyed by the American Association of Individual Investors has fallen to its lowest level since its 1986 inception. 
• On Tuesday, the volatility index (aka, the VIX), which acts as a fear gauge for S&P 500 stocks, hit 37.57, which is only the third time that it broke 30 in the past six months (before then, dating back to August, this VIX had not breached this level since early 2003, as US troops marched to Baghdad).
• Small clusters of options contracts (10 or less, traded by the smallest – and, forgive the description, the dumbest – of options traders) have become very bearish.  Recently about one fourth of their volume was allocated toward puts (a bet on stocks falling); about 25-30% is generally considered an extreme.
• Of Advisors Sentiment figures, the bulls have fallen to 41.6% (the lowest level since August 17th when they were 40.6%).  The bears have jumped to 31.5% (the highest since the 37.4% that persisted at the end of August).  The difference between bulls and bears is 10.1 percentage points (a reading below 15 tends to be positive for the stock market).
• For the last two weeks none of the 42 Fidelity Select mutual funds have outperformed cash over the prior quarter.  This has occurred ten other times since 1986; in all ten instances the S&P followed with a positive 3-month return with an average of 7.8%. 
• The put/call ratio has reached its second highest reading in history (behind only the immediate market fallout after 9/11).

But nowadays it is hard to talk about the stock market without saying “recession” in the same breath.  To steal another excerpt from my recent “Following the Lead” article (which, in part, quoted the Outlook 2008 report), I wrote there “the trend of the LEI is consistent with GDP growth of between 0% and 1%.  This is in line with late December predictions shared with you in our Outlook 2008 report:

‘The final (Q4 2007) GDP number will likely be pretty close to flatline (+/- 1%), with an improvement in Q1 2008 (0% – 1%) thus averting a technical recession for 2007 and mostly likely averting a recession for 2008 (a recession is defined by two consecutive quarters of declining growth).’

That quote was extracted from the portion of the report describing the direction of the economy as ‘Not a Recession, But Still Lousy.’  However, as John Maynard Keynes said, “When the fact change, I change my mind.  What do you do, sir?”  Unfortunately, given the deterioration of the labor markets in December, that description, at best, has been downgraded to ‘hopefully not a recession, but still really lousy.’”

Just for the sake of argument, let’s say that a recession started in December (full data is in for October and November and growth seemed existent).  In all ten recessions since 1945, there have been decent gains following the lows of the S&P 500 during those recessions.  Referring to the below chart (courtesy of Ned Davis Research), the average (aka mean) return from the market lows during recessions have been 15.8%, 24.1%, 32.2%, and 32.4% 3-, 6-, 9-, and 12-months later.

The average decline of the stock market during a recession, from peak to trough, is about 25%.  So, if indeed we did end up sliding into a recession, hitting my 1,300 risk level on the S&P 500 does not necessary mean that all is clear.  An average decline, if this period does turn out to be a recession, would put the S&P at 1,171 points.  And the average bottom of a stock market decline during recessions is about five or six months from its start.  So if a recession started in December then, on average, we should expect 1,171 points in May-June for the S&P 500 (a fairly attractive 15X trailing earnings).

Sticking with those averages, which is beginning to touch upon a worst case scenario that goes beyond my Outlook 2008, then 3-, 6-, and 9-months after the June bottom (September 2008, December 2008, March 2009) we would see the S&P 500 at 1,356, 1,453, and 1,548 points, respectively. 

That’s not necessarily great, but it’s not the end of the world.  But right now it feels that way.  And according to contrary opinion, that’s a bullish feeling.