Whistling Past the Graveyard: Market Assessment and Outlook
Well what an astonishing and astounding week - the single worst one, as a whole, we've had in post-war America and it seems since the Great Depression. Now when we use the words contagion and metastasis perhaps we'll all have a reference point, and hopefully not too many more. To be honest seeing a decade's worth of market change compressed into 5-10 days exceeded any of our prognostications. Even though we've been using the words for months, if not years, seeing and experiencing it in action is a lot different than just intellectualizing about systemic risk and market collapse. Our shock, awe and puzzlement is rather widely shared - which is scary and comforting. Comforting in that it's company, scary in that we'd like somebody to know what's going on.
And we see some glimmers of that beginning to emerge - that the light is not just another freight train with the throttle rammed wide open. Which must sound more than a little odd given our normal "bearish" stance and outlook. Let me explain. And discount all you like - part of our outlook is more than likely built on straw-grasping but we hope more is built on solider grounds.
Market Perspectives
Let's start with a longer term market perspective and reach back to 1994, which given the depth of the collapse we need to do. Rather like a climber sliding down an icy ravine who needs to self-arrest before slipping over the edge of the cliff onto the rockfield below the markets needed to halt their freefall. That's very much not an invented metaphor btw - been there, did that, here to tell it. As you can see looking at the charts the level of drop has taken us back to the nadir of '02, or just about. And the VIX index, which measures volatility = fear, uncertainty, doubt and panic, reached un-precedented levels. HOWEVER, if you go back to '04 when we began all this and apply some natural speed limits, or recurring patterns (technically called Fibonacci limits) we arrested just short of the cliff edge. Whew. Which is not to say that there's more possibly in store, just that we're not going to go sailing off the edge to our (figurative) deaths but have an opportunity to pick our way to the bottom carefully !
Market Details
Let's tunnel down a bit and de-construct the recent market behavior to see what we can see. The accompanying chart shows the SP500 for three time periods:2002-08, three months and the last five days with each more detailed chart a blowup of the higher-level one. Again the market crash was unprecedented and destroyed almost all the last six years of "progress." Quotes because it was ill-grounded as we're learning. Breaking it down the ~20% drop this month was actually concentrated in the last few days. In fact looking at the three month chart you can see where those of us anticipating a bounce had some grounds. On the five day chart the fractalism continues with the bulk of the crash happening just this week. For those of you withe the courage of our "convictions" who were short/inverted this was a great week. For those of us in cash - o.k., not bad. For those of you who were blindly following standard practices we're sorry to see that. Here's the ray of hope in the carnage. Late Friday afternoon which started by looking like another slide toward the cliff the markets self-arrested and almost broke even before last minute, and sensibly risk-averse profit-taking. The keys to whether or not that turns into a bear market bounce lie in the credit markets. And if we get such a bounce make sure you re-construct your portfolios, please ! There's still a lot more Main St. downturn to go once we get the crisis on Wall St. contained. Which means btw that this weekend's G-7 meetings are the keys to all our collective futures.
Credit Crisis
It's always easier to follow and understand the equity markets but the heart of this crisis is in the credit markets, which froze, locked up and spread to the equity markets. This chart looks at 3Mo Treasuries for four years and YtD (divide by 10 to get interest rates). Normally this is a stable market that follows along with the Fed rates. But you can see the BSC disruption in March and the huge flight to safety in the last few weeks as investors rushed out of all other investments and into the safest things they knew. And in the process almost drove interest rates to 0% ! The YtD chart shows that these markets are still severely discombobulated but nowhere near where they were when Sec. Paulson hit the panic button. But it ain't over 'til it's over - that is until these markets return to something resembling normalcy. Which they haven't.
Credit Discombobulation
Which you can see in this next chart which shows the TED spread, or difference between 3Mo rates and the LIBOR - the rates fixed in London for banks to lend to each other. Normally that spread is as near zero as possible but once the crisis started last summer it began widening rapidly. Yet the piecemeal approach being followed to address the crisis was actually working. While the spread was still swinging wildly it the general trend was downward. Until suddenly it wasn't ! In fact it literally metastasized nearly instantaneously. If Paulson hadn't spoken up about a rescue package this would be much..much worse. Be glad our understandings of markets and policies is vastly improved over the wrong-headed policies that brought us the Great Depression. Now you're going to hear all the same people who were whining about the moral hazard problem now complaining that the proximate trigger was allowing LEH to collapse. What we think happened is that when the House Rips put ideology and partisan advantage over the good of the country that the markets suddenly realize the fragility of the ecology and the depths of the problem. Perhaps a necessary wakeup call but surely there were and are better ways to more gradually bleed off the poisons than sudden amputation.
Again, we repeat, developing a coordinated set of policies will dictate where we go from here. This weekend could be one of the most important in your life.
After the break you'll find our usual collection of readings that back all this up but please read Jim Jubak's column on re-structuring your portfolio: Everything's changed now -- for the worse.
Market Perspectives
Wild Day Caps Worst Week Ever for Stocks The Dow Jones Industrial Average capped the worst week in its 112-year history with its most volatile day ever, as hopes for a major international bank-rescue plan were overwhelmed at day's end by another wave of selling. Some investors who normally would be jumping to buy beaten-down stocks after a 22% drop over eight trading days said the relentless declines have left them shell-shocked and unwilling to take new risks. Some spent the day trying to protect themselves from further declines. The Dow fell 697 points shortly after the opening bell, and remained down most of the day. It surged to a 322-point advance less than half an hour before the close. Investors stampeded into bank stocks as reports circulated that the Group of Seven leading industrial countries was going to agree on a plan to rescue major banks, and that Morgan Stanley had been assured that it would receive funding from a Japanese bank. Hopes briefly blossomed that the worst might finally be over.
- Irrational Market As market turmoil defies conventional wisdom, WSJ's Andy Jordan profiles a behavioral economist's take: vengeance, and opportunity.
- Stocks Slave to Credit The biggest thing the stock market needs is some thawing in the frozen credit market, according to S&P's Alec Young, and may have another 15% to 20% to drop. Stacey Delo reports.
Five Days, 1900 Points, and No Solution A programmer for the trading desk at an electronic foreign-exchange and equity network was smoking outside a financial office in Jersey City, N.J., around 6 p.m. Thursday. The man was red in the face and glassy-eyed from exhaustion. “Look at me,” he said. “It’s a flush. It’s a panic.” He said one client, a hedge fund, lost $30 million on Thursday alone. The relentless selling throughout the week leaves many an investor much less wealthy and sporting a thousand-yard stare that would rival a deer wandering out onto the Adirondack Northway to find themselves facing an oncoming tractor-trailer. “I’m a certified financial planner and I’ve been doing this for 20 years, and I’ve never seen volatility that could even come remotely close to this,” says Ken Roberts, principal at Harbors Lights Financial Group in Manasquan, N.J. Casual suggestions to close the market for a day, an erratic thought a few weeks ago, seem like a rational course of action while authorities attempt to save the global banking system, which has self-immolated on the back of debt obligations upon debt obligations, and insurance contracts on top of those debts. Without a sense of understanding that an injection of liquidity into the banking system would jump-start a machine that has ground itself into the mud, the investment community remains frozen, able to sustain a rally so long as nobody notices it exists — such as the sharp turn late on Friday that took the Dow up nearly 300 points, one that disappeared inside of 15 minutes. Some may take comfort in the fact that the major averages pulled out something other than a rout, but this is folly in a week when the Standard & Poor’s 500-stock index lost 15% of its value. It’s akin to an all-night celebration by Miami Dolphins fans after the gridiron squad finally gutted out one win amid 15 losses in the 2007 season. The rapidity of the decline overwhelmed many savvy investors. The Dow’s 1,000-point swing Friday represented the widest one-day trading range for the 30-stock average in his history. Its decline of 18.2% is the worst for a week in its history; the 1874-point drop also marks a one-week record for the average. “It’s feeling like this is bottomless,” Mr. Roberts says. “Obviously, we know it’s not bottomless.” Such a happening knows few post-World War II peers: the week of the 1987 crash was the ninth-worst week, attributable to one day. The week of Sept. 11, 2001 is fifth-worst, and was a psychological reaction to external events. Unlike that week, the market owns this slump.
Market Outlook and Strategies
Where Do We Go From Here? These are extraordinary times. I know there will be those who believe the markets should be allowed to work or simply want those who created the crisis to pay. I do understand the anger. I too am angry, and have been for a long time. Those of us who saw this crisis coming are frustrated that no one bothered to pay attention. But now that we are in it the midst of the crisis, there is no going back. We must look forward and do what we can to avoid an even worse crisis and potential depression. I believe we can do so if governments act promptly. We are already in what will prove to be one of the longer recessions on record. If we look at the Leading Economic Indicators, which have about a 9-month forward-looking view, it will be late next year before we start to grow once again. Given that everything peaked last October through January (sales, employment, etc.), it is likely that the recession will be dated from the beginning of this year. I have been fielding calls all week asking me if I think we are close to a bottom in the stock market. And my answer is, we are close to a short-term bottom, but I think we will trade lower over time due to what I think are going to be poor earnings for the next few quarters. If you are a trader (and that means you have been doing it for some time - not the time to get on the job training!), then maybe you can catch a rebound, which is overdue. But (and here is the big caveat) if there is no global coordination on some or all of the recommendations I made above, this is not going to be pretty. It will end in tears. Let's hope the authorities can get their collective act together.
Everything's changed now -- for the worse I was wrong. I no longer think we're facing a garden-variety recession. At a minimum, it will last longer than the two quarters I projected on Sept. 30. Economists are now talking about a recession that will last three, four or even five quarters. (Keep some perspective here, please. We're still not looking at anything like the Great Depression. In 1932, the economy contracted by 13% and unemployment hit 24%.) And I don't think we're looking at anything like the hoped-for V-shaped recovery, in which the economy zooms out of the bottom, showing growth of 5% or more. The economy, I believe, is going to crawl off the bottom with growth that's likely to linger at less than the 2.5% the Federal Reserve calls the U.S. economy's noninflationary speed limit.I no longer think this is the typical bear market, not even if your benchmark is the painful one of 1973-74 or the excruciating one of 2000-02. Stocks now face a triple-whammy. First, a slow-growing economy will keep earnings growth depressed from levels investors now regard as customary. That means price-to-earnings ratios will have to come down to something below the historical averages for stocks. Second, the higher interest rates will cut into earnings further as all companies have to pay more to raise capital and as some companies defer expanding production or developing new products completely. In industries where this deferral leads to supply lagging demand, it will also lead to higher inflation, which will push up interest rates. And third, the deleveraging of bank and industrial balance sheets that will occur as a result of this crisis means companies will be less profitable in the years after the crisis than they were when cheap money enabled them to bump up reported growth. The news of the past week supports the shift in my view toward a recession that will last longer than previously expected and a recovery that will be slower than previously expected. So how should you position a "rethinking everything" portfolio? Begin building the "rethinking everything" portfolio by dividing your stock market assets into four unequal parts. Part 1, the largest part, is cash. I'm going to raise my cash position in the portfolio to 40% from the current 30%. Part 2, 20% of the portfolio, will remain in natural-resources stocks. Part 3, another 20% of the portfolio, will go into high-dividend stocks in sectors with good growth prospects beginning in the second half of 2009. Part 4, the last 20% of the portfolio, will go into growth at a very reasonable price -- PE ratios of 25 or less to reduce risk in a sell-off, and price-to-earnings growth (PEG) ratios of 0.75 or lower.
The bottom is still to come, says one market timing indicator In today's column, I want to focus on a related way of assessing whether a major bear market is nearing its final low: A gauge I first introduced more than 15 years ago that I call the "Market Timing Popularity Indicator." This indicator measures where the average adviser lies between the extremes of buy-and-hold and market timing. Historically, buy-and-hold tends to reach its peak of popularity at market tops, just as market timing becomes most out of favor. The inverse tends to be the case at market bottoms. For example, that means that, as a bear market approaches its final low, at least a few die-hard believers in long-term buy-and-hold throw in the towel and become latter-day converts to market timing. That has yet to happen, however, at least as judged by my reading of the 200 newsletters monitored by the Hulbert Financial Digest.
10 Bullish Charts, Signals, Indicators Earlier this week, we discussed several anecdotal pieces of evidence that suggested we were closer to the bottom then the top. Today, we look at specific data and charts that can provide some insight as to how extreme these present levels are. These suggest to us that we are increasingly close to a bottom that can be purchased for an upside trade of 20-30% from these levels. NOTE: We scale in over time, in 10% increments, and recognize that the bottoming process can take several months to several quarters to complete. Hence, slowly buying in is the key.