Weekly Market Commentary, February 5th 2008
The current market environment is among the most difficult I can remember. Each day we are hit with a range of information that tells us either we are in a recession, entering a recession or nowhere near a recession. Both the bulls and the bears have reams of data at their disposal which will allow them to articulate a persuasive argument. Within this mass of confusion, stock prices fluctuate, volatility increases, trading volumes expand and fear takes control. Whether you are a short term trader or buy and hold investor, the level of uncertainty affects you.
When dealing with conflicting information, I attempt to ground myself. As a value investor, the easiest way to do so is by looking at the economy, the risk premium of the market, the competitive advantages of individual companies and deriving a price at which I would like to own certain businesses. Doing so allows me to develop a foundation for what I would like to own and why I would like to own it. At that point, I can forget about the pundits on television, the arguments over the direction of the economy and focus on the future. If my thesis is correct, I will be buying solid companies with good business models at a discount to their true value. If incorrect, I can quickly identify where I was wrong and adjust accordingly. Within this framework, I have eliminated the noise and focused on the key aspects of the investment decision making process that allow me to add value.
Considering this macro view, where are we now? For months I have described how a worsening housing environment and incremental steps by the Federal Reserve (Fed) would prove futile. In the first three weeks of this year, the markets began to recognize the problems we face and drove both the Dow Jones Industrial Average (DJIA) and S&P 500 below my fair value targets. While the markets were unraveling, policy makers were acting. During January, the Fed reduced interest rates by 125bp. The Federal government has responded by pushing a stimulus package that includes rebate checks and tax incentives for businesses. Together we have a monetary and fiscal response to the current credit crises that rivals the actions last seen after 9/11/01 terrorist attacks.
For me, this is the key factor that has altered my market stance. While I never liked market valuations last summer and the weakness in housing has had a draining effect on the economy, recent stock valuations were never as absurd as those seen during the dot-com bubble and the economic impact of a housing and credit collapse is much less than one would expect after terrorist attacks. The Fed’s current action of reducing interest rates dramatically ensures people seeing adjustable rate mortgages (ARMs) reset will not experience large payment shocks. Other borrowers with exotic loans will see payments drop, negative amortization cease and now have the chance to remain in their homes. Together, we should approach a point where mortgage defaults decline, housing prices stabilize and people begin to reenter the housing market. On the consumption side, tax incentives and rebate checks will provide the means for an over-leveraged consumer to continue spending. This should result in an increase in economic growth and a sharp recovery.
Considering this economic boom that is to occur, one could ask themselves what took so long for the policymakers to take action? Simply, the costs are high and may outweigh the benefits. By reducing interest rates dramatically, the Fed weakens the dollar and increases the costs of food, energy and imported goods for all Americans. By reducing taxes and sending rebates, the Federal government increases the deficit and our reliance on foreign sources of capital. This massive stimulus raises the question of where the money will come from and how we will ever pay for it. To save us today, we are mortgaging our future.
Despite my long-term reservations, I consider this action bullish. While today’s massive 370 point drop in the DJIA does not lend support to my bullish call, I will treat it as another opportunity to cover my short positions and add assets. With my expectation of a strong second half economy and low stock valuations, we have entered a period where we can begin buying stocks aggressively. Over the past week, I have increased my net exposure from 35% to 55%. Over the coming weeks, I will look for opportunities to become 75-85% net long with an emphasis on financial and commodity companies. As the volatility of the markets stay high, opportunities will develop for the patient investor willing to commit capital in uncertain times. By focusing on your investment thesis and controlling emotions, you can use this time to build a solid portfolio that will outperform over time.
ABOUT THE AUTHOR: Sean is the President of EPIC Advisors, LLC, and also is the #1 ranked and followed trader on Covestor.com. .
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Awesome read Sean. I find your bullish stance on the market very interesting. With the rate cuts so massive I expected more of a rally out of the market, but the value really was seen with the support around 2200 for example on the NASDAQ. I recall you citing this is a great opportunity to start putting money to work. Personally I would like to see lower lows, perhaps support on the NASDAQ around 2275, then press higher from there.
Not #1 ranked on Covestor anymore, yeahhhhhh! But seriously you’ve got some great commentary, I’d love to interview you for my site, if possible